Crime at the Bond Desk

If you're a typical investor, you probably have both stocks and bonds as part of your portfolio. However, although many investors use brokerage firms with online-order entry to buy and sell stocks, fewer individual investors actively trade individual bonds. For the most part, bond trading is a game that consists of larger financial institutions competing with each other.

Part of the reason for this is that the bond market doesn't provide as much visibility in its operations as the stock market. In particular, bond offerings involve a limited number of potential underwriters who are used to competing against one another. Whenever a situation like this exists, there's always a chance for firms to collude with each other to increase their overall profits. Now, banks and other financial institutions are facing allegations from the federal Department of Justice that they illegally colluded in violation of antitrust laws.

The invisible bond market
When it comes to comparing stocks and bonds, the stock market gets all of the glamour. When the Dow or another major stock index hits all-time highs, the news makes the front pages of newspaper business sections across the country. In addition to its higher visibility in the media, the stock market is also more accessible to average investors, and it provides a more liquid market for trading securities. Nearly anyone can pull up real-time stock quotes during regular market hours and place simple trades to buy or sell stocks. Spreads between bids (the price that buyers are willing to pay for shares) and asks (the price sellers are willing to take) are now often just a penny or two for actively traded issues. It's also easy to see charts of price action throughout the day, with tick-by-tick moves that give information about nearly every single trade that occurs in a given stock. Dozens of websites can give you detailed information, including data on stock trading and fundamental analysis of the company's business operations and financial results.

In contrast, the bond markets are much less visible to the everyday investor. In large part, ordinary investors don't look to bonds for trading profits; instead, they consider fixed-income securities the stable part of their portfolio, and therefore look to hold the bonds they've purchased until those bonds mature, making repeated buying and selling unnecessary. Although financial brokerage firms like Fidelity have started to offer individual bonds to retail investors, it's often difficult to get both bid and ask prices from the same broker on any but the most commonly traded bond issues. Also, bond market quotes haven't become as ubiquitous as stock prices.

Hiding below the radar
It is perhaps this lack of visibility that set the scene for the Department of Justice's probe into municipal bond activity. According to the Bloomberg article, JPMorgan Chase (NYSE: JPM  ) , AIG (NYSE: AIG  ) , and Bank of America (NYSE: BAC  ) have received subpoenas in connection with an investigation into rigging bids for a certain type of fixed-income security known as a guaranteed investment contract. These contracts are used by municipalities to save money raised in a municipal bond issue but not yet needed to pay expenses on the related public project.

Municipal bonds are issued by cities and state and local government agencies. In order to issue municipal bonds, government entities need the assistance of an underwriting firm. Although many government entities traditionally retained underwriters through a competitive bidding process, some government bodies now negotiate deals directly with individual underwriters, rather than opening up the process for bids. The key is whether the government entity gets a favorable deal for issuing the bonds. An IRS review of one transaction for the city of Atlanta suggested that the winning underwriter may have arranged for other financial institutions to submit bids that they knew would be too low to win, simply because it would make the process look more competitive. Because municipal bonds are free from federal taxation, any manipulation of the municipal bond market can not only harm issuing government entities, but also defraud the federal government of potential tax revenue.

Although the particular investments at issue in this investigation are not typically used by individual investors, the appearance of impropriety in one area of municipal bond trading may reflect badly on other aspects of the market. Bond trading has long been plagued by wide spreads between buying prices and selling prices; in the past, it wasn't unusual to see a bond broker add two full points to the price of a bond, increasing the cost of a $1,000 bond by $20. Although this may not seem very large, when you multiply this $20 by the number of bonds sold, the figures quickly add up.

Defending yourself from bond fraud
Unfortunately, the relative size and lack of liquidity among some specialized bond markets makes it more difficult for individual bond traders to protect themselves. In general, investors who want to buy Treasury bonds can count on high levels of liquidity and resulting tight spreads. In part, this is because even individual investors can participate in direct offerings of Treasury bonds through the federal government's Treasury Direct program. The regular supply of new Treasury debt keeps competing firms in the secondary market in line. Similarly, other large segments of the bond market, such as municipal securities by large issuers like New York and California, can have enough activity to keep prices at efficient levels for trading.

On the other hand, if you live in a state with less municipal bond activity, or you want to buy corporate fixed-income securities that don't trade as actively, you may be vulnerable. You may want to consider using a mutual fund specializing in the type of bonds you want rather than trying to purchase individual bonds yourself. While bond funds will have associated expenses, and you won't be able to specify a particular bond type or maturity, you will have professional managers with the clout to get the best pricing available on desirable bonds.

The latest ongoing scandal in the bond market provides a valuable reminder: As investors, you must always be aware of the potential for abuse. If you know where potential danger lies, you can take action to avoid dangerous transactions and protect yourself.

Further Foolishness:

The Fool offers many helpful tools that give you the basics on particular areas of investing. To learn more about bonds and fixed-income securities, check out the Fool's Bond Center.

Bank of America and JPMorgan Chase areMotley Fool Income Investorselections.Try the Fool's dividend-focused newsletter service free for 30 days.

Fool contributor Dan Caplinger uses Treasury Direct but otherwise relies on bond funds for his fixed-income investments. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't create a scandal.


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