Buying Bonds Online: Where's the Upside?

It may be easy to do, but the fees can be stiff

Would you buy a General Electric bond yielding less than a U.S. Treasury security? Of course not. GE debt may boast a rare AAA credit rating, but investors have always demanded a better return on money lent to a corporation than on a risk-free Treasury.

Still, Charles Schwab's Web site recently offered such a seemingly unattractive deal on a GE issue. The bear market in stocks has prompted online brokerage firms to beef up their bond offerings, making it easier than ever for individual investors to purchase corporate, municipal, and U.S. government agency bonds as well as Treasuries. But when BusinessWeek reviewed the bond sites of five of the largest online players--Schwab, Fidelity, E*Trade, TD Waterhouse, and Harrisdirect--we found that investors don't necessarily get a good deal unless they buy bonds at the time they are issued.

These brokers revolutionized stock trading, but they have largely stuck to industry practices when it comes to bonds. These include charging stiff commissions on small transactions and not always being up front about what those fees are. Unless you do big trades, you will find better deals with new issues or a type of corporate bond tailored for the individual investor.

For many sorts of bonds, most online firms allow investors to purchase as little as one bond at a time--approximately a $1,000 investment (minimums for municipal bonds run from $5,000 to $10,000). But we found that the prices offered on small trades were so high and the yields so low that they weren't worth it. For instance, Schwab recently listed the price of a GE note carrying a 5% coupon and maturing in June, 2007, at $1,111.20 for investors who wanted to buy a single bond. (A bond's face value--the amount you receive at maturity--is $1,000. Because the GE bonds pay investors interest at their 5% coupon rate, they sell for more than their face value to bring the yield in line with today's low interest rates.) For investors willing to buy 10 bonds, Schwab's price dropped to $1,061.70, or $49.50 less per bond. In the first case, an investor would earn 2.5% vs. a 3.6% yield on the 10-bond purchase.

Similarly, Schwab recently asked $1,216 for a single Treasury note maturing in May, 2007, which gives it a yield of 1.8%. An investor buying 10 of these bonds at once would pay $1,166.50 per bond, lifting the yield to 2.8%. The only way to know that Schwab charges different prices for the same bonds depending on how many you buy is to enter different investment amounts when using the site's bond inventory search functions. Otherwise, the site doesn't make that clear.

Why are small trades so costly? George von Zedlitz, vice-president of sales and service in Schwab's fixed-income division, says that Schwab charges a minimum markup--typically $54.95--regardless of whether you buy one bond or 10. What is the markup on any one purchase? Good luck trying to find out. At most brokerage houses, commissions are embedded in a bond's price rather than broken out, as with stocks. Since most bonds don't trade on centralized exchanges, it's nearly impossible to find out what the brokerage firm paid for the bonds and thus determine the markup.

Schwab, for instance, doesn't show markups on its site, although von Zedlitz says its reps will disclose a markup to a client who asks. At TD Waterhouse, spokeswoman Melissa Gitter says investors are charged a $50 minimum markup. Like Schwab, it will give more information if the customer inquires. Fidelity and E*Trade don't disclose their markups.

Harrisdirect, however, has broken ranks by spelling out commissions. It charges a flat $45 fee, except for large trades of more than 45 Treasury bonds or more than 15 corporate, U.S. agency, and municipal bonds. In the latter case, the fee is $1 per Treasury bond and $3 for each of the other bonds, up to 50 bonds, and $2 per bond after that. "The average investor is only recently getting interested in bonds, and so we didn't want to confuse our customers with bond markups," says Maryann Wasik, managing director of product development at Harrisdirect.

In addition to markups, some online brokers tack "service" or "transaction" fees on small purchases. Fidelity levies a $50 charge on fewer than 21 Treasury bonds. And E*Trade slaps a $40 fee on purchases of fewer than 20 Treasury bonds, or fewer than 10 municipal, corporate, or agency bonds.

With all these complicated and varied price structures, it's difficult to compare costs on the same bonds at different firms. Of course, that's true even if you use a full-service broker. When it comes to corporate and municipal bonds, another problem is that you'll rarely find the same issues listed on the different brokerage sites. For instance, Schwab and Fidelity listed only a handful of the same issues among the dozens of California municipal bonds recently offered for sale. This lack of uniformity makes comparison shopping difficult. The industry practice is for brokerage firms to buy large blocks of bonds from dealers and hold them in inventory for customers. There are hundreds of thousands of corporate and municipal issues; not all firms carry the same ones.

What should you do? Unless you're going to invest at least $10,000 to $20,000 in a single fixed-income security, you should avoid buying all but new-issue bonds. And take a look at a new type of medium-term corporate note that is designed specifically for individual investors. These securities are issued by big companies such as IBM, Household Finance, and United Parcel Service. The notes are always sold at their face value of $1,000, so you pay the same price regardless of where you buy them. They are widely available through brokers: Fidelity makes it especially easy to buy them, listed under "Corporate Notes Program." The coupons on new purchases are reset weekly to reflect prevailing interest rates. Recently, three-year notes from General Motors Acceptance Corp. yielded 5.05%, while Caterpillar Financial Services' five-year notes yielded 3.65%. These bonds range from nine months to 30 years in maturity. One caveat: Their secondary market is small, so these bonds are meant for buy-and-hold investors.

To obtain a fair price on U.S. Treasuries and municipal bonds, buy new issues as well. You can purchase government bonds through the TreasuryDirect online program, which charges no commissions and will send you e-mail alerts of coming auctions. Many of the online brokers will also send you auction e-mail alerts. The ones we reviewed, however, charge online investors $25 to $50 for bonds they purchase on an investor's behalf at Treasury sales.

Online brokers can help you be a smart bond shopper, mostly by putting a lot of general information at your fingertips. But when you're ready to buy specific bonds, view any online firm as a research source rather than your one and only destination.

By Susan Scherreik

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