Many bond funds trade constantly in search of higher yield or capital appreciation. Well, individual bondholders want upside, too. So, when might it make sense to sell a bond you already own to buy another? Though there are some rare cases when it’s a smart thing to do, most of the time, you’re giving up more than what you get back from your trade. I’ll explain why that’s usually the case and then list a few situations when it does make sense.
The main reason why bond trading is usually a bad idea is the cost. The cost is sometimes not readily apparent or even ignored, but it impacts returns regardless. Bond funds can trade in much higher volumes than most individual investors and can trade through institutional channels. They can negotiate much better prices than Main Street customers.
Bonds don’t trade like common stocks; they trade more like cars. The dealer’s profit is embedded in the sale price. The dealer margin is called “markup” and, in the case of some speculative issues, can run as high as 5%.1 In an older study from 2016, Standard and Poor’s estimated the average markup for an investment-grade corporate bond was 0.85% while the average for an investment grade municipal was 1.21%. Though that’s not too bad as a one-time expense, it can begin to pile up with frequent trading, especially considering how little yield is available these days. Want to know how much the markup is? Ask. Most honest brokers will tell you. You can also shop around for your bond purchases; just make sure you are comparing the exact same bond.
This low interest rate environment makes it tempting to exchange low coupon bonds for higher yielding ones but, almost always, there’s a tradeoff between safety and yield. In a normal interest rate environment, long maturity bonds yield more than short maturity bonds, but they also carry more price risk when interest rates trend higher. Lower quality bonds carry a higher risk of the issuer defaulting on its obligation to pay you back principal and interest. Usually the trade isn’t worth it.
There are times when trades do make sense. Taking tax losses by swapping a bond you own with a paper loss for a similar, but not identical bond might offset capital gains taxes (check with your tax professional first). If your bond has fallen in credit quality, it might be too risky for you to have in your portfolio. That’s a sell. This choppy economy has led many formerly conservative bonds to be downgraded, so it wouldn’t hurt to review your bonds to make sure they’re still acceptable.
The last reason to swap bonds is when your situation changes. If your personal financial situation is changing, then you might need to adjust the risk in your portfolio to reflect that. For example, some retirees may have less room for surprises than many younger investors. Likewise, if you have a child who’s going to go to college in a few years, it’s a good idea to think whether you can afford your bonds’ values to back off when tuition payments are coming due.
A well-constructed bond portfolio should hold few surprises and have relatively low turnover. If you want risk, consider different investments instead of being a frequent bond trader.
1https://www.fidelity.com/viewpoints/investing-ideas/how-much-for-bonds
Evan R. Guido is the Founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or eguido@aksalawealth.com. Read more of his insights at https://finance.heraldtribune.com/category/ask-guido/. Securities offered through Avantax Investment ServicesSM, Member FINRA, SIPC. Investment advisory services offered through Avantax Advisory ServicesSM, Insurance services offered through an Avantax affiliated insurance agency. 8225 Natures Way Suite 119, Lakewood Ranch, FL 34202. The views and opinions presented in this article are those of Evan R. Guido and not of Avantax Wealth ManagementSM or its subsidiaries.