When a Brookfield Investment Management Inc. analyst saw bonds of Accuride Corp., the wheel manufacturer in Evansville, Indiana, at 94 cents on the dollar in December, he decided it was time to buy. The problem was the price wasn’t real. The debt was only available at 104 cents.
“When it actually came time to shake them loose from somebody’s hands, that’s where the disconnect came in,” said Richard Cryan, co-manager of high-yield corporate debt at the New York-based firm, which oversees $150 billion of assets. Unable to find a seller at the lower price, they gave up.
Five years after BNP Paribas SA (BNP) marked the start of the worst financial crisis since the Great Depression by halting withdrawals from three investment funds that owned subprime mortgage securities, repercussions are lingering in the credit markets. What investors see still isn’t what they can get.
The reasons now aren’t bonds backed by mortgages made to people who couldn’t afford them or too much corporate borrowing or Wall Street’s slicing up of securities into varying degrees of risk. Bond buyers’ confidence is being sapped by the unintended consequences of regulations meant to make banks safer by requiring them to hold more capital and fewer risky assets.
Rules from U.S. Congress to the Basel Committee on Banking Supervision have caused bond dealers to cut their inventories of corporate securities to levels last seen a decade ago. With Wall Street diminishing as a middleman, investors such as Brookfield are struggling to trade in the $4.8 trillion bond market that’s the financial lifeblood of corporate America.
Holdings of company debt at the 21 primary dealers that trade with the Federal Reserve shrank 84 percent to $37.5 billion last month from $235 billion in 2007, according to the central bank.
“It’s definitely a challenge to put money to work in this market,” Cryan said in a telephone interview from New York.
Investors used to easy trading of securities are hoarding bonds, knowing that if they sell, purchasing new debt may be prohibitively expensive, and acknowledging that if they need to raise cash, ready buyers could evaporate. For bond buyers, the changes are akin to the difference between buying a pair of shoes from inventory in a store and ordering from a showroom, then waiting for delivery, said Ashish Shah, the head of global credit investments at AllianceBernstein LP in New York, which oversees $230 billion in fixed-income assets.
While record-low central bank rates have reduced borrowing costs and prompted companies to increase bond sales, the active secondary market in U.S. corporate debt is shrinking.
New issues of $829 billion this year are up 14 percent from the same period of 2007, according to data compiled by Bloomberg. Trading of the securities among the dealers has dwindled to an average of about $95 billion a day this year from more than $235 billion in all of 2007, Fed data show.
Money managers are shifting to “a longer time horizon” because any security may become difficult to unload, said Jason Brady, a managing director at Santa Fe, New Mexico-based Thornburg Investment Management Inc., which oversees $80 billion.
Taking that risk may mean added costs for corporate borrowers, even though yields on their bonds have declined to 3.94 percent as of Aug. 7 from 6.77 percent five years earlier, according to Bank of America Merrill index data. The premium they pay over benchmark Treasuries has widened to 268 basis points, or 2.68 percentage points, from 202 in August 2007.
As bond dealers step back, more than 75 money managers from BlackRock Inc. (BLK) to Fidelity Investments to Western Asset Management Co. (WMC) are planning cheaper and more efficient trading through electronic systems.
MarketAxess Holdings Inc. (MKTX), the owner of an all-electronic bond and derivative trading system, said it hosted 13.2 percent of U.S. investment-grade debt trading in July, up from 11.2 percent in the same period of 2011. The firm introduced a feature last month that Wall Street has resisted for years: the ability for investors to buy and sell bonds among themselves.
“Clients now are finding the cost to rent the dealers’ balance sheet has gone up,” Richard McVey, chief executive officer of MarketAxess, formed by Wall Street banks in April 2000, said in an interview at the company’s New York headquarters. Dealers on the platform still clear the trades.
The trading networks pose another threat to Wall Street profits. JPMorgan (JPM) Chase & Co., Bank of America Corp., Citigroup Inc. (C), Goldman Sachs (GS) Group Inc. and Morgan Stanley took in $11.8 billion in the second quarter from fixed-income trading, excluding accounting adjustments, or 15 percent of their overall revenue. That’s down from $13.1 billion in the same period a year earlier.
Banks get trading revenue from the difference between the prices they quote to clients to buy and sell debt, or the bid- offer spread. When they reach trade agreements over the phone, there’s less competition than on an electronic system in which banks have to vie for business in auctions.
“The buyside feels the dealers hide behind what they essentially consider fishing,” or putting out a fake price to attract clients, said Will Rhode, director of fixed-income in New York at Tabb Group, a financial-markets research and advisory firm. “It gets very frustrating.”
Moving to electronic bond-trading systems may reduce costs by as much as five times, according to research by Terrence Hendershott, an associate professor at the University of California at Berkeley’s Haas School of Business, and Ananth Madhavan, the global head of trading research at BlackRock.
A study of comparable trades from January 2010 to April 2011 executed on MarketAxess’s electronic system versus others reported to the Financial Industry Regulatory Authority’s Trace bond-price reporting system showed a cost of 6.09 basis points on MarketAxess and 30.43 basis points in over-the-counter transactions reported on Trace, Hendershott and Madhavan wrote in a Jan. 13 paper.
Banks still have the advantage, Tabb Group’s Rhode said. “The sell side still has the momentum because it’s traditionally been very hard for the buyside to create all-to- all markets,” he said. “That’s the Holy Grail for them.”
Electronic efforts have had a mixed history. One reason is that bonds usually trade over-the-counter, not through exchanges. Another is that while each company has one stock, it can have thousands of debt securities, all with different characteristics. Fairfield, Connecticut-based General Electric Co. (GE), the largest corporate issuer, has more than 1,300 bonds outstanding.
BondBook LLC, a venture by securities firms including Merrill Lynch & Co. and Goldman Sachs, shut down in October 2001 after eight months of operation. BrokerTec Global LLC agreed to a takeover by London-based ICAP Plc in August 2002.
Andy Nybo, director of derivatives at Tabb Group, listed some of the failed computer-trading efforts in an April report, including BondBook, Bond Connect, BondGlobe, BondHub and BondLink. “And that’s only the Bs,” he said. “Remember Intervest, Visible Markets or XBond?”
Successful electronic trading systems may not increase the ease of buying and selling bonds, Thornburg’s Brady said.
“Having a really good thing that matches buyers and sellers is not going to make half of them want to buy and half want to sell at any one time,” Brady said. Excluding dealers and their ability to hold debt in inventory is an impediment to success, he said.
Executives at Fidelity, the second-largest mutual fund company, and State Street Corp., both of Boston, met in May with representatives of Deutsche Bank AG (DB), Barclays Plc (BARC), JPMorgan and Goldman Sachs, urging the dealers to develop an electronic- trading system for bonds, according to people who attended the event and asked not to be named because they weren’t authorized to speak publicly. The group will meet periodically in the next 12 to 18 months, the people said.
The world’s largest asset manager, New York-based BlackRock, which oversees $3.56 trillion, said in April it plans to allow its customers to buy and sell bonds.
Goldman Sachs, the fifth-biggest U.S. bank by assets, has its own initiative, GSessions, which debuted in June. The New York firm started with two five-minute trading sessions a day, one for an investment-grade bond and another for junk debt, which is rated below Baa3 by Moody’s Investors Service and BBB- at Standard & Poor’s.
Morgan Stanley is retooling an electronic bond-brokering system. The Morgan Stanley Bond Pool network picks a group of securities and matches buyers and sellers who express interest through the system, offering lower transaction costs than what investors typically get in privately negotiated trades, the bank said in marketing documents dated last month and obtained by Bloomberg News. Created last year, the system was revamped in May, and the bank introduced the new version to clients within the past month, a person familiar with the matter said.
Western Asset Management and Janus Capital Group Inc. (JNS) have held discussions with Bonds.com (BDCG) Group Inc. to use the electronic trading service, people familiar with the matter said this month. New York-based Bonds.com appointed former Jefferies Group Inc. fixed-income co-head Thomas Thees as CEO in June. The fund managers, which oversee a combined $599 billion, haven’t made a decision to use the system.
Other electronic trading systems for fixed income include Tradeweb Markets LLC and Bloomberg Tradebook from Bloomberg LP, the parent company of Bloomberg News.
“You’re talking about a sea change here,” said Mike Buchanan, the head of global credit at Pasadena, California- based Western Asset, which oversees $446 billion. “While it may take a while, it’s going to happen.”
The changes so far are a result of the regulatory response to the credit crisis. The 27-country Basel committee in 2010 raised the minimum capital requirement for the largest banks to almost 9 percent of risk-weighted assets from 4 percent. In the U.S., the Dodd-Frank Act’s Volcker Rule will limit the risks that deposit-taking banks can accept, reducing dealers’ willingness to keep bonds on their balance sheets.
Rule makers are “causing a shift in market structures with institutional investors seeking alternative ways to access liquidity,” said David Parker, head of high-yield sales at Vega-Chi Ltd., the operator of a trading system in Europe for convertible and speculative-grade bonds that plans to offer a service in the U.S. in September. “They want the banking business model to revolve around lending and not holding large trading positions and trading.”
The credit crunch ignited five years ago when defaults on mortgages provided to the least creditworthy home buyers surged to record levels, causing the value of bonds containing the debt to plummet. When two Bear Stearns Cos. hedge funds imploded that June from subprime mortgage bonds and collateralized debt obligations, investors fled to all but the safest debt, making it even harder to value less-traded securities.
On Aug. 9, 2007, Paris-based BNP Paribas halted withdrawals from three investment funds that had declined 20 percent in less than two weeks because it couldn’t “fairly” value their holdings. That triggered a panic that eventually led to $2 trillion in writedowns and losses at the world’s largest banks, Bloomberg data show.
By the following March, Bear Stearns had imploded and was sold to JPMorgan in a Fed-backed deal. The crisis reached a crescendo in September 2008. Fannie Mae and Freddie Mac, the largest U.S. mortgage-finance companies, were placed into government conservatorship. American International Group Inc. agreed to a U.S. takeover to avert collapse. Merrill Lynch was forced to find a buyer in Bank of America.
Lehman Brothers Holdings Inc., which had become the biggest underwriter of mortgage-backed securities as the U.S. real estate market peaked, filed for the largest bankruptcy in history that same month, and credit markets froze. Goldman Sachs and Morgan Stanley were forced to transform into bank holding companies.
The bond market has returned 47.6 percent in the past five years, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield master index. The total return on the S&P 500 stock index has been 5.9 percent in the same period.
Even though the crisis is over and there’s no lack of money for those who need it, the credit market is still going through fundamental changes as Wall Street’s traditional role evolves.
For Melissa Weiler, a money manager who helps oversee $10 billion at Crescent Capital Group LP, the message came through recently when it took her team took two months to unwind a retailer’s bonds from their portfolio. Before the crisis, that would have been done in less than a week, she said.
“If you decide to exit a name because the credit is deteriorating -- guess what? -- you’d really like to sell at the quoted level of 95 but you might have to be willing to accept a price of 90 or less given the lack of liquidity on a given day,” Weiler said in a telephone interview from the alternative credit-asset manager’s office in Santa Monica, California. “Timely execution has increasingly become a challenge.”
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