Part 1 - Basic structure of the fixed-income market
Although the fixed-income market is more than twice as large as the equity market, it is generally followed less closely by the media and is less well understood by the general investing public. This opening section of the Beginner's Guide will examine some of the ways in which fixed income differs from equities, who the major players are in the fixed-income market and what advantages and disadvantages individuals face when trading fixed income.
How fixed income differs from equities
There are numerous contrasts between the fixed-income market and the equity market, but when it comes to trading, there are two differences that are of paramount importance. The first difference to consider is the sheer number of securities available in the fixed income market. Whereas someone interested in investing in the stock of General Electric (GE) only has one security to consider, that same person would have thousands of securities to choose from if he or she wanted to invest in the bonds of GE. Similarly, investors in the Treasury market have hundreds of offerings available.
The positive aspect of having so many different issues to choose from is that investors can usually find a security that very closely meets their needs. The flip side of this, however, is that investors need to have a process for determining precisely what their investment needs are, and then screen the fixed-income universe for the security that most closely matches those needs.
The second major difference between fixed income and equities is in the area of price transparency. Stock prices are publicly known and changes are relayed instantly to all market participants. Therefore, an investor in the stock market can be reasonably certain he or she is getting a fair market price at the time of his or her purchase (of course fair market price and intrinsic value can and often do differ greatly). On the other hand, in the bond market, trades are executed dealer-to-dealer or dealer-to-investor. This means that there is no central record of all of the transaction prices in the bond market. Furthermore, the sheer volume of issues outstanding means that some bonds may not trade for days, weeks or even months at a time.
These circumstances can leave investors uncertain of what a fair price for a given bond truly is. Fortunately, there are steps investors can take to assure that they are getting at least a reasonably fair execution level. We will look more closely at those steps later in this guide.
SEE: 6 Biggest Bond Risks
Who are the major players in the fixed-income market?
Another difference between the fixed-income market and the equity market is the importance of institutional investors. While it is the large institutions that move prices and dominate trading in either market, retail investors are generally far more active in the equity market than they are in the fixed-income market. Because of this, investors executing small stock trades generally do not suffer a penalty, relative to those trading larger sizes. This is not true in the fixed-income market.
Because institutions so thoroughly dominate the fixed-income market, the average trade size is quite large (a round-lot trade in fixed income is often millions of dollars' worth of bonds). Investors buying odd lots, or amounts smaller than $1 million, might find themselves paying a penalty, relative to the price they would receive for a larger position. Because fixed-income returns have historically been lower than equity returns, a seemingly minor price discrepancy when buying or selling can actually wind up "costing" an investor a substantial portion of his or her prospective returns over time.
Advantages individual investors have
The preceding paragraphs have discussed some of the challenges individuals might face when investing in the fixed-income market. However, there are also several advantages that smaller investors may have. The first advantage is that long-term investors don't have to pay attention to daily market movements. This freedom allows individual investors to seek out attractive long-term opportunities, without worrying about short-term market fluctuations that might occur.
A second advantage that individuals might have is that they can consider a wider range of issues than many institutions. Institutional investors often have extremely rigid investment policies that dictate what issues they can and cannot buy. By being slightly more flexible, an individual can seek value in the bond market wherever it occurs.
A final advantage that individual investors have is that they can choose not to trade when valuations aren't attractive. A bond mutual fund manager or other institutional investor generally doesn't have a choice whether or not to buy bonds; cheap or expensive, the investor must purchase bonds as new money flows in or as old bonds mature. An individual can choose to allocate more money to the stock market, however, or to a money market fund, as opposed to buying bonds if he or she finds that valuations are not attractive. Similarly, when prices appear reasonable, individuals can choose to purchase more bonds for their portfolios. This flexibility does not exist for most institutional investors, and is a significant advantage for the individual.
SEE: Bond Portfolios Made Easy
Beginner's Guide to Trading Fixed Income: Part 2 - Process for trading fixed-income securities
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