The right bond at the right price: Understanding bond pricing. Smart bond buying could save you thousands.

The right bond at the right price: Understanding bond pricing. Smart bond buying could save you thousands.

Executive summary Compared with stock market investing, it s not always easy to know what is included in the price you pay for a bond. The market can be fraught with hidden costs. The same bond can be priced significantly differently from firm to firm, sometimes resulting in thousands of dollars in additional costs. By better understanding bond pricing, you can take ownership of your investments, hold your brokers accountable, and help ensure you re getting the right bond at the right price. There are a number of factors that can impact a bond s price that you need to know about. Among many other factors, changing interest rates, credit ratings, and the liquidity of a particular bond can all influence the price you pay. When you buy and sell individual bonds, there may be a number of costs that are included in the price. The bid-ask spread, mark-ups, commissions, and concessions are among these potential costs. We believe bond investors should follow a process before investing to ensure you are buying the right bonds at the right price. First, define your goals for investing in bonds. Next, search for the right bonds to meet your needs. Finally, shop for the best price on those bonds. We ll show you how Schwab can help with each of these steps. 1

The importance of bond pricing If you re like most consumers, you shop around to make sure you ve found the best price for a new car or for other major household items. Before making such purchases, you probably spend time researching your options, asking questions, and making sure you re getting the best value for your money. Do you go through the same careful process when you invest in a bond? If you re like most investors, you probably don t. In fact, according to the recent Bargain Hunting For Bonds survey, even among self-described bargain hunters, only 17% of respondents say they shop around for the best price on bonds. 1 Many stocks trade on a central exchange with competing buyers and sellers and you can be assured that you re getting the best price available. However, this is not necessarily the case with many bonds. Most bonds trade directly between bond dealers in what s called an over-the-counter market (OTC market), which is away from a central exchange. As a result, it is a more fragmented market, with less competition between dealers for the best price. Therefore, prices can vary widely from one dealer to another. As you can see from the table below, the difference could potentially add up to thousands of dollars for each bond purchase you make. Factor in any number of hidden costs, and you may not even know this is happening. These additional costs can make a real difference in whether or not you can reach your retirement goals. Comparing bond prices could save you money Bond Quantity Price at Firm A Price at Firm B Total cost paid at Firm A Total cost paid at Firm B Potential savings Bond A 125 104.49 103.11 $130,613 $128,888 $1,725 Bond B 150 103.63 101.26 $155,445 $151,890 $3,555 Bond C 200 101.00 99.07 $202,000 $198,140 $3,860 The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. The right bond at the right price: Understanding bond pricing 2

Bottom line, you shouldn t be in the dark when it comes to bond investing. The retail bond market has evolved, so investors now have much better access, pricing, and guidance than ever before. By understanding the factors that impact bond pricing, you can take ownership and hold your brokers accountable to help ensure you are getting the right bond at the right price. Your potential savings can be significant. Shopping around for a better price on a bond is not difficult, especially with Schwab s help. As you read on, you ll find several important factors to consider, along with some suggested steps to take before buying bonds. Bond prices are often quoted as a percentage of the face value. A bond s face value, sometimes referred to as par, is the amount the issuer originally borrowed and is obligated to pay back when the bond matures. For example, a bond priced at 90 can be thought of as 90% of face value. If the face value of a bond selling at 90 is $1,000, it would cost you $900. When a bond is trading in the market at less than face value (under par), it is said to be trading at a discount. Its price would generally be under 100. When a bond is trading at more than face value (over par), it is trading at a premium and the price will generally be over 100. For example, a bond priced at 110 would cost you $1,100. 3

What can impact a bond s price? The bond market is a network of dealers who sell bonds to one another and to their clients. As an OTC market, the buys and sells for bonds occur directly between two parties rather than on a centralized exchange like much of the stock market. The price paid for a bond can be based on a number of security-specific and environmental factors, such as the interest rate environment, the supply and demand for a particular bond, and the bond s credit quality. A few of the primary factors you need to consider are explored below: Changes in interest rates. Bond prices are sensitive to interest rates in the economy and generally move in the opposite direction. All else being equal, when interest rates fall, the price of a bond rises. Conversely, should rates rise, prices of existing bonds are generally expected to fall. Generally speaking, bonds with longer maturities are more price-sensitive to rate changes. Also, as a bond gets closer to maturity, the price of the bond moves closer to its face value. Credit ratings. An upgrade or downgrade in a credit rating can affect a bond s price and yield. Generally, a downgrade in a bond s credit rating will cause the bond s price to fall. Pay special attention to bonds that have significantly higher or lower yields within a given credit rating. This may indicate that the bond is at risk of a downgrade. Bond dealers may offer a lower price for a less desirable security, such as one that is having credit problems. Liquidity. Liquidity affects how easily you can sell a security without incurring high transaction costs or a reduction in price. Compared to the thousands of stocks that are available to trade, there are millions of bonds. Some bonds trade very infrequently and there may not always be a willing buyer for a particular bond. Liquidity is measured in terms of the bid-ask spread i.e., the price difference between what someone is willing to pay for the security (bid) and what they are willing to sell the security for (ask). For bonds that trade frequently, the difference between the bid and ask may be small. Accrued interest included in the total cost. Accrued interest is the amount of interest that has accumulated since the last interest payment date. Many bonds pay interest every six months, so interest accrues between one interest payment and the next. This means that a bond buyer will pay the interest accrued up to the settlement of the trade to the seller; however, the buyer will then receive the full interest payment on the next interest payment date. The right bond at the right price: Understanding bond pricing 4

Costs involved in buying and selling bonds When you buy and sell individual bonds, there may be a number of costs that are included in the price you pay. Bond prices are often quoted with all of these costs included, making it difficult to determine the underlying price of a bond. Also, unlike most stocks that trade on an exchange for a single price at a given point in time, bonds are generally offered by a limited number of dealers who may price the same bond very differently. Broker-dealer firms will often buy and sell securities for their own inventory. In doing so, the market may dictate a higher price than they acquired the bond for when they sell it. This could include, but is not limited to, a bid-ask spread. In addition to the bid-ask spread, brokers can include an additional mark-up or mark-down in the price of the bond as compensation for negotiating and executing trades on behalf of investors. Similar to a retail store, a portion of this mark-up or mark-down may go to cover overhead, including compensation or salaries for salespeople, as well as profits for the firm. Less frequently, rather than a mark-up or mark-down, a commission may be charged to the investor; this amount will be disclosed on the trade confirmation. For newly issued bonds, compensation is included in the final price in the form of a concession paid by the issuer. Underwriters may provide a dollar discount from the offering price or dollar remuneration for each bond to participating members who market the securities. In some cases, a firm may charge a management fee for professional portfolio management rather than a fee for each transaction. These fees are typically charged as a percentage of the total assets under management, and may vary based on factors such as the type of investment strategy and the size of the portfolio. Let s look at a hypothetical example. A $10,000 5% bond is quoted by Dealer A at a bid price of 102.00 or $10,200 and an ask price of 102.51 or $10,251. The $51 difference between what the bond can be bought and sold for is the bid-ask spread. Dealer B, who has a client interested in purchasing this bond, buys it from Dealer A at 102.51, for a total price of $10,251. Dealer B then sells it to their customer at 104, or $10,400. The $149 difference between what the dealer paid for the bond and what they sold it to the client for is the mark-up. 5

Bond mark-ups can vary widely from firm to firm. According to a July 2013 Patpatia & Associates, Inc. study on fixed income marketing and pricing practices, bond investors can pay mark-ups of up to $21 per bond at some brokerage firms, compared to just $1 per bond mark-up for most online secondary market trades at Schwab. 2 Hypothetically, this $20 price difference would reduce the yield earned on a 4%, semi-annual paying, 10-year bond by.25%. On a $100,000 bond, that would be a total reduction in income of $250 per year, or $2,500 over 10 years. Questions to ask your broker: Make sure you understand any commissions or mark-ups built into the price (and yield) as well as any additional fees. Unless your broker has a standard mark-up policy, you should ask before every trade. Be sure to ask these questions: How much am I paying in commission or in a mark-up on this bond? Do you have a standard mark-up schedule for bonds or does it vary? How much am I being charged in management fees? How to shop for bonds As a bond investor, how can you determine whether you re getting the right bond for your needs at the best price available? The following process can help: 1. Define your goal. Whether you plan to build your own bond portfolio or have it professionally constructed, start by clarifying your objective for investing in bonds and consider how they will fit into your overall portfolio and your financial plan. Are you investing in bonds to preserve capital, diversify your portfolio, or generate income? Depending on your answer to this question, you may want to increase your focus on safety in your portfolio, or you may want to maximize the income you receive from your portfolio. How can Schwab help define your goal? A financial plan is an important place to start. As your partner in planning, your Schwab Financial Consultant listens to you and gathers information relevant to your life. Using this information along with financial modeling, your Schwab Financial Consultant then works with you to develop practical plans that fit your life and help you achieve your goals. This plan will include helping you choose the right mix of investments. As a Schwab client, your planning sessions are available to you at no cost. 3 The right bond at the right price: Understanding bond pricing 6

2. Find the right bonds to meet your goals. The next step is to search for bonds that align with your risk tolerance and financial goals. A balanced fixed income portfolio combines a variety of bond types. Consider the following principles: Diversify. Choose securities that represent many different issuers to help reduce your exposure to any single bond s loss of value. Stick with quality. Invest the bulk of your bond portfolio in high quality fixed income. While lower quality bonds may offer higher interest rates, they usually have higher risks as well. Hold to maturity. Plan ahead and choose bond maturities that match your cash flow needs or investing goals. Unless a bond defaults or gets called away, you ll earn the interest payments and get all of your principal back when it matures. When searching for the right bonds, consider whether your broker is able to shop around on your behalf to find the best available bonds for your needs. How can Schwab help find the right bonds to meet your goals? Schwab s BondSource platform offers access to professional research and user-friendly bond search and filter functionality, as well as access to over 36,000 new issue and secondary bond offerings from more than 200 dealers. We connect to multiple major bond trading platforms, not just one. 4 When you re choosing bonds, there s no substitute for one-on-one guidance from an experienced professional with deep market knowledge. At Schwab, you can talk with our team of specialists who focus exclusively on fixed income and draw on an average of over 19 years of experience in the financial services industry. 5 3. Shop for the best price available. Doing a little homework to find the right bond at the right price can pay off. Because different dealers may have very different prices for the same bond, comparing prices from multiple dealers is a good way to help make sure you don t pay too much. Take the example below of a $10,000 5.875% Wal-Mart bond offered at prices ranging from 122.847 at Firm A to 124.684 at Firm B. If an investor purchased the bond at Firm B, they would have paid $183.70 more than if they purchased the same bond at Firm A. Thanks to our wide selection of bonds, you ll have multiple options to help meet your goals. Bond $10,000 5.875% Wal-Mart Bond, CUSIP 931142CH4 Price at Firm A Price at Firm B Total cost paid at Firm A Total cost paid at Firm B Potential savings 122.847 124.684 $12,284.70 $12,468.40 $183.70 For illustrative purposes only. Prices may not be reflective of current market prices. 7

How can Schwab help shop for the best price available? We help you get the right bond at the best price available on our platform. As a bond investor, you are automatically presented with the lowest price available to Schwab for a bond. You can easily cross-check that price against other prices Schwab has received for the same bond by searching for the CUSIP on Schwab BondSource. The example below shows a State of California bond that was offered by five different dealers at the same time on Schwab s platform. In this case, the highest available price is 124.100 and the lowest available price is 120.938. On a $10,000 trade, the difference between the highest and lowest price is $316.40 in additional costs for the same bond. At Schwab, you ll be able to shop for multiple prices on our online platform or with the assistance of Schwab s experienced, dedicated team of fixed income specialists. In addition, we are confident you ll find our pricing is straightforward and competitive. Our $1 per bond transaction costs on most secondary market bonds traded online is among the lowest in the industry (there is a $10 minimum and $250 maximum, plus $25 for broker assisted trades). There are no transaction costs on Treasury bills, notes, or bonds purchased online. Schwab Bond Specialists provide advice and service to Schwab clients specific to their fixed income investing needs. Our Bond Specialists do not earn commissions on each transaction. While Schwab does have access to new issues brought to market, we don t underwrite new issues and our specialists are not compensated for selling these bonds instead of secondary issues that may be available at a better price. Nor does it matter whether a transaction is executed through another dealer or from Schwab s own inventory. Action State S&P Rating Moody s Rating Description Coupon Maturity Qty Price Min Max YTM Buy CA A A1 Buy CA A A1 Buy CA A A1 Buy CA A A1 Buy CA A A1 State of California CA GO 5.25% 09/01/2022 13063BNL2 State of California CA GO 5.25% 09/01/2022 13063BNL2 State of California CA GO 5.25% 09/01/2022 13063BNL2 State of California CA GO 5.25% 09/01/2022 13063BNL2 State of California CA GO 5.25% 09/01/2022 13063BNL2 5.250 09/01/2022 15 120.93600 5 15 2.498 5.250 09/01/2022 15 122.57900 15 15 2.307 5.250 09/01/2022 25 123.08200 10 200 2.249 5.250 09/01/2022 100 123.60700 100 300 2.188 5.250 09/01/2022 50 124.1000 50 350 2.132 For illustrative purposes only. Prices may not be reflective of current market prices. The right bond at the right price: Understanding bond pricing 8

Stay on track Once you ve established your fixed income portfolio, it is important that you monitor and track your investments on a regular basis to help ensure you stay within your risk tolerance and on pace to meet your investment goals. Review your portfolio. Review your portfolio as it relates to your current objectives. Your needs can change and may call for a portfolio adjustment. Monitor your investments. Regularly review your bonds ratings, prices, and other characteristics, and rebalance as needed to stay within your risk tolerance. Evaluate the market. Make sure your portfolio accounts for changing market conditions, like possible trends in interest and inflation rates. Know what your bonds really cost In addition to this process, there are a number of other resources you may find helpful. The Securities Industry and Financial Markets Association s (SIFMA) investor education web sites, such as investinginbonds.com, provide valuable information. You can also find trade history for bonds from the Financial Industry Regulatory Authority (FINRA) via the Trade Reporting and Compliance Engine (TRACE) by visiting http://www.finra.org or through the Municipal Securities Rulemaking Board s (MSRB) via the Electronic Municipal Market Access (EMMA) by visiting http://emma.msrb.org. Before you buy bonds, make sure you understand exactly what you re paying for and shop around to make sure you re getting the best price. You have a right to know. We re here to help. The guidance, selection, and straightforward pricing you ll find at Schwab are structured to help you achieve your bond investing goals. Call a Schwab Fixed Income Specialist at 1-877-566-7982 or visit Schwab.com/BondSource to get started today. 9

1 Bargain Hunting For Bonds: How Investors Shop, an online survey of U.S. investors conducted by Koski Research for Charles Schwab. 2 Patpatia & Associates, Inc. s 2013 Fixed Income Trading in Wealth Management study, released in July 2013, presents findings on the marketing, pricing and support services practices and policies for Fixed Income in the Wealth Management channel of over 15 firms across National Full-Service firms, Regional and Independent Broker-Dealers, and Discount Brokerage and Clearing firms. For more information, visit www.patpatia.com. 3 The consultation is complimentary, although the implementation of any recommendations made during the consultation may result in trade commissions or other fees, charges, or expenses. During the consultation, specific advice and recommendations are limited to assets held at Schwab by clients with an existing Schwab retail brokerage account. Examples may be provided of the advice and recommendations that might be offered if outside assets were transferred to Schwab; however, such information is for educational purposes only. 4 As of December 2013. 5 As of January 2014. The examples provided are hypothetical and provided for illustrative purposes only. They are not intended to represent a specific investment product, service or firm. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. In the bond market there is no centralized exchange or quotation service for most fixed income securities. Prices in the secondary market generally reflect activity by market participants or dealers linked to various trading systems. Bonds available through Schwab may be available through other dealers at superior or inferior prices compared to those available at Schwab. All prices are subject to change without prior notice. Schwab reserves the right to act as principal on any bond transaction. In secondary market principal transactions the price will be subject to our standard mark-up in the case of purchases and a mark-down in the case of sales and also may include a profit or loss to Schwab in the form of a bid-ask spread. When trading as principal, Schwab may also be holding the security in its own account prior to selling it to you and, therefore, may make (or lose) money depending on whether the price of the security has risen or fallen while Schwab has held it. The Bargain Hunting For Bonds: How Investors Shop study has a 4.4 percent margin of error at the 95% confidence level. A total of 514 respondents completed interviews. Survey respondents had a minimum of $100,000 in total investable assets, ranged in age between 25 and 75, do investing on their own and have heard of bonds or fixed income investments. Fifty-one percent of survey respondents own or have owned individual bonds. Survey respondents were not asked to indicate whether they had accounts with Charles Schwab. All data is self-reported by study participants and is not verified or validated. Investors participated in the study between May 16, 2013, and June 1, 2013. Investing involves risk, including possible loss of principal. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Koski Research is unaffiliated with the Charles Schwab Corporation and its affiliates. Patpatia & Associates, Inc. is unaffiliated with the Charles Schwab Corporation and its affiliates. 2014 Charles Schwab & Co., Inc. (Member SIPC). All rights reserved. IAN (0514-1827) MKT81024-00 (04/14) 00118200