How to Understanding Agency vs. Principal Transactions

Have you noticed the notation "agency" or "principal" on your trade confirmations when trading bonds? What does this mean?

Step 1

WHAT DOES AGENCY MEAN? - When you buy a bond from someone who is acting as an Agent, it means they do not own the bond that you are buying. Instead, they are buying the bond from a dealer and the reselling it to you. When the agent buys the bonds, they will pay the dealer's "mark-up". However, the agent cannot then pass another "mark-up" on to you. The agent is obligated to get you a price for the bond (which is what he has to pay the dealer) and then pass that price on to you.

However, of course an agent has to make a living and they earn their keep by charging you a concession or fee on the sale. They pass through the price they paid for the bond, but they charge you a fee for facilitating the transaction. You will often find that brokers at full service brokerages are acting as an agent.

By common industry practice, the fee should be no more than 3% - but you should be able to find agents working for much smaller fees than that! After all in today's interest rate environment, most of your bond interest would be destroyed by a 3% fee! At one large do it yourself brokerage, I found that they charge a flat $1.50 per $1,000 bond. That seems like a pretty good deal. If you are using a full service firm with an individual broker, you will almost definitely pay a significantly higher concession. Make sure you ask the broker what the fee will be and figure it into your projected return.

Step 2

WHAT DOES PRINCIPAL MEAN? - When you buy a bond from someone acting as a principal, it means that they have actually purchased the bond themselves and are holding it in their inventory. The principal therefore takes more risk than an agent because while the principal is holding the bond (waiting to sell it) it could go down in value and he could lose money.

The principal does not charge a fee or concession but rather he charges a "mark-up". If you are dealing with a principal, he can provide you a "bid" and "ask" quote. The "bid" is what he is willing to pay to buy a bond from you, and the "ask" is what he requires in order to sell a bond to you.

The difference between the "bid" and the "ask" is called the "spread" or "mark-up" and it is the profit to the principal.

Step 3

COMPARING THE TWO - From a cost standpoint, you are not necessarily better off using an agent or a principal. But it is important that you understand the difference so you can ask the right quetsions about the bond and determine your net projected return after fees or mark-up's.