Commission costs for buying or selling bonds are hidden. The price is quoted net. Indeed, if you ask a broker about the commission, you may be told that there is no commission. But that is not the case.
Prices of all fixed-income instruments—including mutual funds—are always quoted in pairs: the "bid" and the "ask" (also known as the offer). The difference between the bid and the ask is known as the "spread." It represents the commission. Technically, the bid is what you sell for; the ask, the price at which you buy. But it is not difficult to remember which is which. Just remember this: if you want to buy, you always pay the higher price. If you want to sell, you receive the lower.
For example, a bond may be quoted at "98 bid/100 ask." If you are buying the bond, you will pay 100; if you are selling, you will receive 98 (see below for the answer to 98 and 100 what).
Technically, the bid/ask spread is a market spread, which means that it is the cost of buying or selling for the broker. A broker starts with the market spread and figures out how much additional commission she needs to charge in order to sell a bond to you at a profit. Suppose, for example, that the market spread is "98 bid/100 ask." If you are selling an inactively traded bond (and that description applies to most bonds), then the broker makes sure that she buys it from you cheaply enough so that she will not lose money when she resells. She might then quote a spread to you of "97 bid/101 ask." For that reason, commission costs to an individual investor are often wider than the market bid/ask spread.
For an individual investor, commission costs typically range from ½ of 1% (or even less) for actively traded Treasury issues, to as much as 4% in inactively traded bonds.
Commissions vary for many reasons:
As a rule, bonds that have very low risk have narrower (that is, lower) commissions (spreads); bonds that are riskier or less in demand sell at wider (that is, higher) spreads. Any characteristic that makes a bond less desirable makes it more expensive to sell.
Let's illustrate with some concrete examples. Treasury bonds sell at the narrowest spreads (less than ½% or even less), no matter how many bonds are purchased or the direction of interest rates. High-quality intermediate munis (AA or AAA, maturing between three and seven years) sell at commissions of between ¾% to perhaps 2%. Thirty-year munis sell at spreads of between 3% and 4%. The more strikes against a bond, the more difficult it is to sell. Trying to sell a long maturity, low credit quality bond in a weak market is a worst-case scenario because you have to shop extensively just to get a bid.
The size of the spread (or commission) reflects what is known as a bond's liquidity; that is, the ease and cost of trading a particular bond. A narrow spread indicates high demand and low risk: the dealer is sure she can resell quickly. Conversely, a wide spread indicates an unwillingness on the part of the dealer to own a bond without a substantial price cushion.
An unusually wide commission (4% or more) constitutes a red flag. It warns you that at best, a particular bond may be expensive to resell and, at worst, headed for difficult times. The dealer community, which earns its living buying and selling bonds, has a very active information and rumor network that is sometimes quicker to spot potential trouble than the credit rating agencies.
Note also that when you buy a bond issue, even though the commission is built into the deal, commission costs are usually closer to the actual market price for that bond, at a point in time, than when bonds trade in the secondary market. Hence, the individual investor may receive a fairer shake by buying at issue than by buying in the secondary market.
As already noted, it is difficult to obtain information on spreads and pricing. Dealers are reluctant to reveal markups. And pricing is variable. It bears repeating that the only way to protect yourself is to comparison shop and to do some arithmetic.
Always try to find out the bid/ask spread when you are buying a bond. If the broker does not directly quote the spread, ask what you could resell the bond for if you had to resell it that afternoon (or the next day).
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