Transaction Costs and Market Structure

Bid-ask spreads, OTC trading, and total cost

5 min read

What am I really paying to trade bonds?

Bond Market Structure

Unlike equities (traded on exchanges), most bonds trade Over-the-Counter (OTC). Dealers quote bid and ask prices. No centralized exchange for most corporate bonds. Government bonds have more electronic trading platforms.

The Bid-Ask Spread

Term	Definition
Bid	Price dealer pays to buy from you
Ask (Offer)	Price dealer sells to you
Spread	Ask - Bid (dealer's profit margin)

Typical Spreads

German Bunds: 1-3 basis points (extremely liquid)
Investment-grade corporates: 10-30 basis points
High-yield corporates: 50-100+ basis points
Illiquid bonds: Can exceed 100 basis points

Why Spreads Vary

Issue size: Larger issues = more liquidity = tighter spreads
Credit quality: Higher-rated = tighter spreads
Age: On-the-run (newest) issues are more liquid than off-the-run
Market conditions: Spreads widen during stress

Other Costs

Brokerage commission: Per-trade fee (often embedded in spread)
Custody fees: Annual fee for holding securities
Settlement costs: Clearing and settlement charges

Total Cost = Bid-Ask Spread + Commission + Custody (annualized)

COST CALCULATION

Buy €10,000 nominal of a corporate bond at 101.50 (ask). Sell at 101.00 (bid). Spread cost: €50 (0.50% of notional). For a bond held 1 year with 0.50% round-trip spread and 0.10% custody → ~0.60% drag on returns.

KEY TAKEAWAY

Transaction costs eat into returns. For short holding periods, spreads can exceed your coupon income.

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