Regulatory moves to bring more clarity to over-the-counter (OTC) derivatives have set the industry thinking about other opaque areas of the investment world.
One such investment sphere is that of bonds. Although the media hailed the recent ‘flight to safety’ as equity markets quaked and investors flocked to fixed income, the veneer of respectability accruing by default to bond markets can be deceptive.
Bonds can be as risky as equities and they are certainly not as transparent in terms of pricing. The data capture for more liquid equities is far more sophisticated and it is no surprise, therefore, that murmurs about creating a central tape for bonds have been heard around the City. But is this possible, or even necessary?
Too much detail
Although lay investors have piled into credit, few understand the language of bonds, where different words are interchangeable (but not always synonymous). For example, bonds can be called certificates, credit instruments, paper, notes, company/government debt and, mostly in the US, stocks. The yield can be called a coupon, rate or dividend; the duration can be called its maturity date or tenure; UK government bonds are called gilts, while US government bonds are Treasury notes or T-bills.
Then there is the type of bond investment - government, investment grade, high yield, hybrid (CoCos), junk; fixed or unfixed. Within each of these are a myriad of sub-classes, carrying their own individual bond ratings. Companies have multiple layers of debt. For example, bank debt has several tiers with distinct ratings and risk factors (see ‘Watch out for the waterfall’, below). Malcolm White, head of institutional fixed income sales for Legal & General, says: “You must understand the capital structure of the company whose credit you are buying. Markets have seen a lot of value destruction down the waterfall, from senior debt right down into a company’s equity.”
There are many bond instruments to consider: credit default swaps, collateralised debt obligations, options, structured debt and other packages of credit. Simon Thorp, head of credit at Liontrust, summarises: “Take one company, such as Commerzbank; this alone has more than 59,000 quoted corporate bonds. So the universe is huge and, within that universe, there are some less liquid bonds that have not traded for months, making it nearly impossible to support full pricing transparency in credit markets.”
There are also geographical and currency decisions to make, as well as sector, company type and the company’s rating to consider. On top of this, there are macro factors: inflation, interest rates, Libor rates and monetary policy.
Then there is the duration or maturity: short-term or long-term; two-, three-, five-, seven-, ten- or 20-year bonds, or debt packaged to any maturity date, not to mention the frequency of the interest payment, plus the yield information. In addition, an investor must ask: ‘What is the spread?’
All this must be factored into an investment strategy, whether it’s trying to get a short-term uplift on the sell price, or playing a longer-term game of liability matching. White adds: “Managing portfolio risk is knowing what you have invested in. Many pension funds thought they had a boring bond portfolio and now they are not so sure. The world of bonds is idiosyncratic; you must understand your liability and the nature of the credit.”
Best practice pricing
Because of all this, the buy side needs to ensure that they pay the right price for their bonds. With no central marketplace for the majority of credit products, and no requirement under Mifid to include bonds within best practice trading and settlement, there is no easy way of gauging whether a manager has paid too much for too little cushion.
Thorp explains: “A manager must assess both absolute and relative value pricing. For example, say I find an attractive company within a sector that has good prospects. I will look at its peers in the index on which they trade, so I can get a relative idea of what the spread should be above the risk-free asset.
“We then calculate what cushion we would need to own that credit, cross-check this against similar companies, and then approach a range of brokers to see if they can sell it to us for the desired spread, and for the best price. It’s basically a negotiation process over the phone.”
This method of pricing relies on the relationships that the buy side can develop with the sell side. Evidently, a manager who has a great relationship with a broker can negotiate a better price, within a quicker timeframe, than another company.
It’s not as if bonds are stuck in the dark ages. In 1995, a mere 0.6 per cent of all US bond trades were conducted electronically; by 2009, 57 per cent of the US fixed income market’s average daily volume was traded online, a figure expected to rise to 62 per cent in 2010 (data according to consultancy Celent). And the London Stock Exchange is set for its electronic bond market launch this year (see ‘LSE sets its sights on the retail credit market’, below).
White says: “There are publicly available electronic trading platforms for credit markets, but for more illiquid credit, it is still preferable to use a broker for price discovery and transacting.”
Some measure of efficiency has been created. However, this can cover only the most general bond types and produce an average price based on what the market is paying for something similar. Prices are not real-time and there is still a lack of clarity for less liquid bonds.
Trying to focus
Post-trade securities service providers have been instrumental in bringing transparency to fixed income markets. International central depository Euroclear Bank already offers the Euroclear Euro Commercial Paper Index, a benchmark for bond yields in short-term paper quoted in various currencies and different maturities.
Philippe Mior, director in Euroclear’s strategy division, says that more can be done with this data: “Many of our clients have difficulties in obtaining accurate bond prices. But, since we acquired Xtrakter earlier this year, we can leverage its pricing models. Therefore, we can capture the prices of bond trades throughout the day, and extrapolate this to provide cleaner valuations, which will enhance liquidity.
“It may not be possible to get this pricing data for all fixed-income securities in real-time, but tools that we are developing will help clients to get more accurate valuations for a variety of bonds so that they can compare prices and define just how much they should be paying.”
But there are limits to this model. Mior explains that less liquid bonds that have not traded for weeks are difficult to value. Furthermore, relying on such pricing models will provide only crude data, not a complete picture of a company or sector’s fundamentals. “There are many factors, other than the computed price, that make a bond worth the value at which it is sold, such as a rumour that the firm is in merger negotiations, which can impact the price of its issued debt,” says Mior.
Eyes wide open
Is it worth creating a central tape for bonds? In terms of best execution, there is an argument for more clarity. According to Mior, new technology could create algorithms to provide a form of central tape for the majority of bond products, though Euroclear does not intend to do this.
But, as Thorp explains: “You can’t take the OTC market and make it more transparent in a short period of time. What you can do is look at benchmark areas that have billions of trades a day, where the prices do not move much, and create more clarity around those areas.”
Other players believe a central tape might not work in the brokers’ best interests, as relationships may break down and brokers could lose the franchise or only make 0.5 basis points, instead of brokering a higher-margin deal. Other players might come in and bust a competitor’s trade with a lower sell price.
White says: “The fractured and complicated nature of fixed income makes it difficult, but that is not a reason for doing nothing. A central tape can work if it is created and managed by people skilled at understanding and arbitraging credit risk.”
If managers can price the risk accurately on a central screen, this would help to bring clarity, and a better price, for their clients. But whether the man on the street should use a central tape for bonds is another matter: without understanding the various types of bonds, or the inherent risks of credit, what benefit would mere price definition give him? A little knowledge can be a dangerous thing. n
Watch out for the waterfall
The safest-ranked bank debt is the senior level. The next level down is lower tier two, falling to upper tier two, and at the bottom is tier one debt. If bond investors are holding a lot of tier one credit and the bank falters, they may not get their money back.
LSE sets its sights on the retail credit market
With the UK retail bond market growing apace (the size of the retail UK corporate bond market is an estimated £20bn, for example), the London Stock Exchange (LSE) is launching an electronic bond market for retail investors. It aims to provide an efficient mechanism for enabling liquidity and price transparency.
It currently has more than 10,000 listed bonds on the systems, although to date, none have been traded on the electronic order books. Instead, bonds transactions are still agreed over the counter between counterparties, with the details of the trade reported afterwards.
A spokesperson from the LSE said: “The existing secondary market for retail bonds can be fragmented and private investors may often have difficulty in accessing the bonds they would like to include in their investment portfolios.
“The electronic order book for retail bonds will offer an open model, where dedicated market makers will quote two-way prices in a range of retail bonds throughout the trading day and other market participants can enter orders into the book.”
|