Special Report: The E Bond Revolution
At precisely 11:30 a.m. on Nov. 9, Pittsburgh Mayor Tom J. Murphy aims to make bond market history. With the click of a computer mouse, Murphy will auction $55 million worth of municipal bonds directly to institutional investors over the Internet. The deal would be the first of its kind in the bond market. By cutting out Wall Street's middlemen and appealing directly to buyers, Murphy hopes to eliminate steep underwriting fees and cut the city's cost of issuing bonds by paying a lower yield. "For the first time, we're controlling our own destiny," Murphy declares.
It's Main Street vs. Wall Street, and Main Street may have the edge. Murphy's move is part of a dramatic revolution, fueled by the Internet, that is sweeping the $13.7 trillion market. The impact should be huge, affecting everyone from retail municipal bond buyers to the largest corporations.
The revolution is in the early stages--very few bonds are trading in cyberspace so far. But not many market participants deny the momentum. "The march of the bond market toward electronic trading and distribution is inexorable," says Steven M.H. Wallman, a former commissioner at the Securities & Exchange Commission. According to the Tower Group, a technology research outfit, 37% of all U.S. bonds will be traded electronically in 2001, up from 5% in 1998 and 0.6% in 1995. The projected action in U.S. government bonds is even more impressive: 55% in 2001, compared with 6.5% in 1998.
HUGE SPREADS. Much of today's bond market is an inefficient, 19th century backwater, where investors have to get quotes by calling from broker to broker. Price data and transparency are minimal. A tight oligopoly of Wall Street brokers and dealers controls prices. Spreads between what dealers charge and investors pay can be huge. Dealers annually collect some $25 billion in spread revenue.
A flourishing if fledgling band of electronic devices is changing all this. The Net is allowing buyers and sellers to bypass the middlemen. Bid/ask spreads could narrow as much as 25%, causing dealers to lose up to a quarter of their trading revenue, or more than $6 billion annually. In the high-yield market alone, where spreads are a hefty 1/4 of a point and up, institutional investors could save more than $800 million annually by trading on an electronic platform. Savings, to both issuers and institutional investors, could be billions of dollars. "Bond investors will have access to more offerings, more information, and better pricing than they have ever had," says Marilyn Cohen, President of Envision Capital Management Inc., a fixed-income firm.
Here's a sampling of the action:
-- MuniAuction, the first municipal auction Web site, will do the Pittsburgh deal on a private-label Web site that it created, where investors can buy bonds directly off Pittsburgh's site. Early last month, Ohio's state treasury held an auction on a MuniAuction created private-label Web site, BidOhio.
-- Ford Motor Credit Co. and American Express Co. are selling commercial paper directly to investors on Web sites. By mid-2000, the top 20 borrowers in the $1.2 trillion commercial paper market will launch a Net trading platform.
-- TradeWeb LLC, an Internet-based electronic-trading system, handles 12% of the Treasuries dealers sell to institutional investors. Early next year, TradeWeb will add agencies.
-- Trading Edge's BondLink, another Internet startup that matches buyers and sellers of high-yield debt, had about $200 million in order flow in one day in mid-October. It will trade convertible bonds and emerging market debt by yearend. By mid-2000, investors will be able to trade munis.
Electronic trading will greatly change how traders operate. Pension funds, mutual funds, and insurance companies will have much better transaction data. But most important, it will reduce trading fees. Paul H. Schultz, a finance professor at the University of Notre Dame, found that for big institutions, such as bond mutual funds, the average trading spread for corporate debt was 27 basis points. That means the typical fund is paying $2.70 above dealers' costs to buy and sell a bond. This depresses the yield and total return to investors. Electronic trading will greatly improve performance.
While Wall Street dealers could lose a lot in spread revenue as a result, there should be an explosion in secondary trading. This will create more liquidity in the market, making it less volatile. "Every investment bank must reinvent how they think about their business," says Hamid Biglari, the McKinsey & Co. partner in charge of the firm's global banking and financial-services practice. And there are other benefits. With the U.S. suddenly facing rising competition across the Atlantic from the growing market for euro-denominated debt, the e-bond revolution will help keep the U.S. bond market the world's No. 1 place to raise money.
One of the major catalysts for the recent push to debt on the Net was last summer's liquidity crisis from Russia's debt default and the near-collapse of the hedge fund Long Term Capital Management. This has prompted many Wall Street firms to cut their debt exposure--creating illiquid trading in many bonds. As a result, institutional investors have been unable to sell bonds when they need to. "A lot more customers got to thinking, `Why should we give Wall Street all our business?"' says one top trader at a large institutional investor.
It's about time that the highly fragmented bond market underwent a transformation. In the market today, there is no central tape on which to report trades and there are no exchange floors where buyers and sellers can meet. In fact, most of the 4.5 million individual bonds outstanding trade only sporadically, and even then most transactions are handled over the old-fashioned telephone. Now, technology is changing the balance of power. "There is a shift in the bargaining power from the sell side [dealers] to the buy side [institutional investors]," says Biglari, the McKinsey & Co. partner.
Automating the sprawling bond market requires dealing with the many dozens of segments, chiefly Treasury securities, corporate bonds, and municipals. Newly issued bonds, many of which are held until maturity, are also divided into segments. Some are put up for bid while others are bought directly from issuers. Much of the action is in the secondary market. There are several systems: institutional investors who trade anonymously with dealers but not with each other; dealers who trade with each other, and others who match orders anonymously. All of these systems have attracted slews of firms competing to automate the process.
MANY AUCTIONS. Most new online bonds are issued on the Internet through one of the primary market-bidding systems, which allow dealers and investors to bid directly on new bonds. The municipal market has been the most progressive. Historically, muni issuers went to banks and Wall Street dealers to sell their debt. The issuer would pick one firm to buy the entire bond deal or there would be a competitive sale among brokerage firms. The buyer of the bonds would then re-offer them to institutional and retail investors, marking up the price before the sale.
Pittsburgh has done seven online auctions in the past two years, but only with dealers. So far, the city has saved taxpayers a total of $1 million. Gross commissions paid to underwriters are typically about $5 a bond, but Pittsburgh has paid about $2.50 a bond online. Another benefit: The buyer didn't have to purchase the entire deal. Smaller, regional dealers could participate and buy portions of the issue. Myles C.S. Harrington, president of MuniAuction, is taking the auction process to corporations and institutional investors. "Think of E-Bay and apply it to the bond market," says Harrington.
InterVest also uses the auction process and charges fees of 0.1%, to 0.15%, significantly less than the 0.7% that Wall Street demands. On the $250 million of investment-grade bonds it has auctioned so far, it has saved borrowers $1.4 million. "We're starting to see Wall Street's loss of power and control over the bond business," says Larry E. Fondren, InterVest's founder.
More companies are getting ready to issue small portions of their debt needs online. Only a few, though, have been willing to step forward because many don't want to anger dealers. Those most likely to issue bonds online are those with household names, such as AT&T. Investors are beginning to view these bonds as safe and as liquid as Treasuries. "Retail investors are a large and promising market for us," says Edward M. Dwyer, treasurer of AT&T. "That's where we might go for electronic distribution."
Issuers are also incorporating electronic road shows into their debt offerings. Federal-Mogul Corp., a frequent borrower, uses Bloomberg and the Internet to broadcast road shows. "We can reach a wider audience, it's more cost effective, and it allows everyone to use their time more efficiently," says David A. Bozynski, treasurer of Federal-Mogul.
When bonds are issued directly to the investor, there is concern whether they will be traded by the dealers in the hugely important secondary market. Typically, the dealers buy the bonds with their own capital, and then distribute them among institutional investors. Corporate issuers fear that if they cut out these powerful middlemen, bond prices will fall in the secondary market because there won't be enough liquidity to buy and sell huge blocks of bonds. "Dealers will be less likely to bid on bonds if they didn't issue them," says Robert Upton, senior director of financial institutions at Fitch IBCA. While borrowers may benefit from lower financing costs, "what's the good of saving money on underwriting fees, if the bonds trade at higher levels in the aftermarket," says Robert Iati, a senior analyst at the Tower Group.
MAJOR POWER. The secondary market has many more electronic options than the primary market. The multidealer systems such as TradeWeb or Bloomberg BondTrader are electronic bulletin boards, where dealers post their inventory of offerings. Traders sometimes call to get a final price.
TradeWeb has emerged as one of the most powerful systems in the secondary market, and has been a force in moving the bonds onto the Web. It is a joint venture of seven of the largest bond trading firms, including Lehman Brothers Inc. and Merrill Lynch & Co. As of early October, TradeWeb's daily trading volume was up to $4.5 billion, nearly double what it was in May. Clearly, TradeWeb is filling a need. Look for agencies on TradeWeb in early 2000. "Trading agencies is a natural progression from Treasuries," says TradeWeb President James W. Toffey.
Most institutional investors use TradeWeb for somewhere between 20% and 80% of their Treasury market trades and they usually find better prices. "If we're getting better execution, it's coming out of the dealer's pocket," says Curt A. Mitchell, head of fixed-income trading for Loomis, Sayles & Co.'s $18 billion in bonds. Mitchell uses TradeWeb for some 75% of his Treasury trades.
The system has attracted some heavyweights, such as Robert Auwaerter, a senior fixed-income portfolio manager at Vanguard Group. A tougher customer than most, he looks at TradeWeb and then calls two or three dealers as a "sanity check," while most managers just go directly with TradeWeb information. More than half the time, Auwaerter gets better pricing on TradeWeb. How much better? Perhaps only 1/64 of a point; but on a $15 million trade, that's $2,343. "That's real money," says Auwaerter, "and if you lose that on execution, that's free money you're giving away."
Better price execution isn't the only incentive for institutional investors to go electronic. "We see these systems as a tool to increase productivity, manage more money, and handle more transactions," says James M. Keller, treasury specialist at Pacific Investment Management Co., with $150 billion in bonds under management.
Several systems specialize in matching trades. They include a handful of startups, such as Trading Edge's BondLink and LIMITrader, which trade high-yield debt, and State Street's Bond Connect, which trades corporates, treasuries, mortgage-backed securities, and agencies. They bring buyers and sellers together to trade in real-time, or match trades periodically. Trader anonymity is a big plus.
Collectively these systems should foster greater liquidity, despite Wall Street's resistance. Eventually, Wall Street will have to join, rather than fight: mainly due to the growing power of the assets controlled by institutional investors. "Some of the larger buy-side firms have as many resources as some of the dealers in terms of research or trading, and might see the benefit of those systems that disintermediate [cut out] the dealers," says Robert Kramer, head of taxable bond trading at Fidelity Investments.
The competition in the electronic interdealer broker market, where dealers trade anonymously with one another, is also under siege. Instinet Fixed Income will be launching its system next year and begin trading treasuries and euro-denominated government debt. "We kept hearing who was going to be the Instinet of the fixed-income market, so we decided to be," says Douglas Atkin, president of Instinet, a unit of Reuters Group PLC.
BrokerTec Global is another key player. It is backed by the biggest bond dealers on Wall Street, including Citigroup, Morgan Stanley Dean Witter, and Merrill Lynch. It will make its debut sometime next year and will initially trade the same securities as Instinet Fixed Income. These two new systems will compete with Cantor Fitzgerald LP, a huge player in the interdealer broker market for Treasuries. Cantor recently filed to do an initial public offering on its E-Speed electronic system. What the market is waiting for in secondary trading is a multidealer, Internet-based platform complete with full trading and execution capabilities. Although not yet available, market experts say it may not be more than two to three years off. After that, day trading in bonds may become much more common.
No doubt there will be winners and losers in this revolution. Dealers that understand they must restructure their bond business, and cut costs by embracing new technology, will come out on top. "We are completely convinced that the operating model of the future is significantly different from that of the past," says G. Kelly Martin, head of global debt markets for Merrill Lynch.
To preserve its domain, Wall Street is hedging its bets by developing its own internet trading platforms, partnering with rivals, as dealers did for BrokerTec and TradeWeb, or buying out internet startups. For example, Merrill Lynch plans to make nearly all fixed-income products executable on its Web site sometime next year. Goldman Sachs, Morgan Stanley Dean Witter, and Salomon Smith Barney are also embracing technology. One likely scenario has the dealers separating into two businesses. There will be the electronic division, which will include lower-margin bond sales, trading, distribution, and execution. This is the area that the Internet startups are moving in on. Then there will be the higher-margin, value-added advisory service side of the business. Firms will look for new growth opportunities, such as customized product creation for domestic and European markets.
Some believe that an even larger transformation is about to sweep over the bond market, such as one drastically simplifying the way bonds are created. "There are bigger changes to come in terms of the whole structure of corporate finance that will obviate some of the problems arising from having thousands of different securities issues," says Wallman. But until then, all eyes are on the budding e-bond market.