While the U.S. Dodd-Frank Act’s Volcker Rule has curtailed the ability of banks to use their own money for trading, the biggest money managers have stepped in, using their growing buying power to absorb at a discount large amounts of bonds that get put up for sale. Those are opportunities that smaller buyers may never see.
Dealers’ reduced capacity to trade bonds is a boon to the largest investors, who can buy large chunks of bonds at attractive prices. Smaller buyers may never get those offers.
“A lot of these Wall Street dealers often don’t like to have to make 20 or 30 phone calls” to sell a block of debt, so “it may make sense to make a call to one or two big money managers and offer the securities at once,” said O’Neil, whose Total Bond Fund has outperformed 75 percent of its peers over the past five years, according to data compiled by Bloomberg.
The business of bonds is changing after stricter capital requirements and risk-curbing rules prompt the world’s biggest dealers to shrink their balance sheets and staff. Banks are working more closely with the largest asset managers than they did before the 2008 financial crisis after cutting their company-debt holdings by 76 percent since the peak in 2007.
Now “the dealer has to act in a pass-through” capacity, turning to larger investors when clients ask them to sell bonds, said Dan Fuss, vice chairman at Loomis Sayles & Co. in Boston, which oversees about $210 billion. “The smaller firms are starting to gripe on this.”
The largest bond-fund managers have expanded their share of a market that’s doubled in the past decade to more than $40 trillion, Bank of America Merrill Lynch index data show. Pacific Investment Management Co., Vanguard Group Inc. and Fidelity manage 39 percent of all mutual fund-owned taxable bonds today, up from 18 percent in 1997, according to Morningstar Inc. data. The smallest 205 fund providers manage 0.1 percent of the market.
The dominance of the biggest managers has caught the attention of the U.S. Securities and Exchange Commission. The SEC is examining whether the biggest players get preferential prices and access because of their influence, Bloomberg News reported on March 20, citing people with direct knowledge of the matter who asked not to be identified because the probe hasn’t been made public.
The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms is drawing scrutiny, with regulators concerned that smaller investors are being penalized, according to the people.
Fidelity was able to buy a chunk of debt at a “very, very attractive price” last June and July when “competitors were being hit with a lot of redemptions,” forcing them to sell, O’Neil said.
Investors pulled a record $51.6 billion from taxable-debt funds in June, Morningstar data show. The withdrawals came in response to speculation that the Federal Reserve would pare its securities purchases sooner than investors expected.
The proportion of corporate debentures in Fidelity’s Total Bond Fund increased by about six percentage points in July to about 40 percent of its holdings, the biggest monthly increase in at least two years, Bloomberg data show. After corporate debt globally lost 2.4 percent in June, the debt gained 1 percent the following month as the Fed maintained the pace of its asset buying, Bank of America Merrill Lynch index data show.
“The big banks would love to be able to do this and hate calling Fidelity, Vanguard or anybody and saying, ‘Here is an opportunity we used to make all the profit on, how much of it will you take?’” said Erik Gordon, a professor at the Ross School of Business at the University of Michigan in Ann Arbor. “The bankers make these calls only because they have to deleverage their balance sheets.”
The Volcker Rule, which bans banks from making speculative trades with their own money and limits their stakes in some private funds, was adopted Dec. 10 by five U.S. financial regulators. The rule, named for former Fed Chairman Volcker, imposed the restrictions in response to the 2008 credit crisis.
Bankers have pushed back against some of the rule’s provisions, particularly with respect to so-called market making, the business of using a firm’s capital to buy and sell securities with customers.
While some investment managers are willing to step in when rivals are being forced to sell, they aren’t providing liquidity on a daily basis the way Wall Street used to. Without as much dealer involvement, it’s generally taking longer to buy and sell debt, Fuss said.
The 22 primary dealers that trade directly with the Fed held a net $5.9 billion of speculative-grade bonds as of April 9, down from $8.4 billion in February and the lowest amount since July, Fed data show. Junk bonds have returned 3.4 percent this year, Bank of America Merrill Lynch index data show.
“The dealers are more constrained than they used to be despite the low rates,” Fuss said. “It must be frustrating for them. I feel bad for them because their business model was not built around this.”
Trading hasn’t kept pace with the unprecedented expansion of the market. U.S. corporate-bond trading volumes have risen 5 percent since 2009, to an average of $20.8 billion a day this year, according to the Securities Industry and Financial Markets Association. That compares with a 56 percent surge in the amount of dollar-denominated debt outstanding, Bank of America Merrill Lynch index data show.
Wall Street’s loss has proved Fidelity’s gain.
“We like the Volcker rule,” O’Neil said. “That has created more opportunities for us in the last year or so.”
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