Bond Allocation Probe Seen Symptomatic of Race for Yield

The federal investigation into the way banks divvy up new corporate-bond sales may shed light on a side effect of regulations that were designed to make the financial system safer.

Rules issued in 2010 by the Basel Committee on Banking Supervision and the Dodd-Frank Act passed by Congress prompted Wall Street bond dealers to cut their inventories of the debt. That leaves them less to offer asset managers in the secondary market and may create an incentive to favor buyers of new issues that trade in large volumes.

Smaller money managers that trade less frequently are often excluded from gains that new deals can generate, according to interviews with more than a dozen investment firms. The U.S. Securities and Exchange Commission is investigating the way the biggest banks allocate corporate-bond offerings and whether they are giving preferential treatment to certain clients, according to a person with direct knowledge of the matter.

“Investors aren’t being treated equally,” said Jeffery Elswick, director of fixed-income at San Antonio-based Frost Investment Advisors, which oversees about $5 billion in fixed-income securities. “We’ve had a broker-dealer tell us there’s nothing we can do. We’ve had another say that unless we did much more volume with them in the secondary market, there was very little we could do.”

Unprecedented Stimulus

While those complaints aren’t new, the stakes have multiplied in the five years since the credit crisis as unprecedented central bank stimulus pushed government-bond yields to record lows and drove investors into higher-yielding assets. The race for yield has helped fuel $18.9 trillion of corporate-bond issuance since the start of 2009, according to data compiled by Bloomberg.

Investors who won a piece of Forest Laboratories Inc.’s $1.8 billion sale of junk bonds in January have been rewarded with a $125 million gain in about a month, five times the price appreciation on the same amount of the Bank of America Merrill Lynch U.S. High Yield Index, data compiled by Bloomberg show. Those returns come on the heels of a one-day profit of $2.54 billion reaped by buyers of Verizon Communications Inc.’s record $49 billion offering in September, a deal for which money managers put in orders of as much as $100 billion.

‘Tremendous Demand’

“There’s so much talk in the marketplace now about tremendous demand for corporate bonds and we’re all theoretically fighting over a finite base of securities,” Thomas Murphy, who oversees about $26 billion of investment-grade credit at Columbia Management Investment Advisers LLC in Minneapolis, said in a telephone interview. “There’s more demand than there is supply, so it just makes a sensitive issue more sensitive.”

In addition to bond-issue allocations, the SEC’s review also includes the banks’ trading of bonds after offerings, said the person with knowledge of the matter, who asked not to be named because the probe is confidential. The inquiry is in early stages and may not lead to any enforcement action, the person said.

Goldman Sachs Group Inc.’s annual filing last week added “allocations of and trading in fixed-income securities” to a list of activities at the New York-based firm that are subject to open regulatory scrutiny. That firm and New York-based Citigroup Inc. are among banks being examined, the Wall Street Journal reported last week.

Fee Windfall

The unprecedented corporate issuance has given banks a windfall of fees from underwriting the debt, accounting for a greater share of investment-banking revenue at the same time the money they make from trading the securities in the secondary market diminishes.

Debt underwriting accounted for 12 percent of global banking and markets revenue last year, up from 9 percent in 2009, according to Bloomberg Industries data. It’s a bright spot for banks that have reported lower debt-trading revenues as the new regulations prompt them to reduce inventories held to facilitate transactions in the securities.

Primary dealers that trade directly with the Fed reduced their corporate-debt inventories to $56 billion as of March 27, when the central bank revamped the way it calculates and reports the data, from a peak of $235 billion in October 2007.

Market Doubles

While the amount of dollar-denominated investment-grade notes tracked by a Bank of America Merrill Lynch index has doubled since the end of 2007 to $4.4 trillion, trading volumes haven’t kept up. The average daily volume increased to about $12.8 billion last year from $8.61 billion in 2007, Trace data show. At the end of 2013, corporate bonds were changing hands in chunks that were 39 percent smaller from before the credit crisis.

At the same time, more transactions are taking place on electronic systems such as those run by MarketAxess Holdings Inc. Buyers exchanged $58.1 billion of debt on that company’s platform in January, 15 percent more than a year earlier and the most ever for the month, according to data on the New York-based firm’s website.

“Banks don’t have the balance sheet, and I have new ways to trade,” said Mark McDonnell, a money manager who helps oversee $1.3 billion at Hillswick Asset Management LLC in Stamford, Connecticut. Investment firms’ “ability to sidestep the dealer community is getting stronger and stronger,” he said.

Verizon Deal

The five-biggest U.S. corporate-bond underwriters earned $13.7 billion in fees last year, the most in at least five years and a 26 percent increase from 2009, according to data compiled by Bloomberg Industries.

Banks including JPMorgan Chase & Co. and Morgan Stanley earned $265.3 million from the Verizon deal alone. That offering helped fund Verizon’s buyout of Vodafone Group Plc’s stake in Verizon Wireless. The order book for the deal was said to grow to between $95 billion and $100 billion, people familiar with the deal said at the time. Goldman Sachs wasn’t among the underwriters on the Verizon sale, while Citigroup was part of a group that managed a smaller share of it.

The 10 largest buyers obtained $22.1 billion, or 45 percent of the offering, with the top five buying $16.25 billion, according to a person familiar with the sale, who asked not to be identified citing lack of authorization to speak publicly.

Pimco Allocation

Pacific Investment Management Co., which runs the world’s biggest bond fund, purchased $8 billion of the debt while BlackRock Inc., the No. 1 shareholder of Verizon, was awarded about $5 billion, people familiar with the sale said at the time.

Mark Porterfield, a spokesman for Pimco, didn’t return e-mail and telephone messages seeking comment, while Brian Beades, a spokesman for BlackRock, and John Nester, a spokesman for the SEC in Washington, declined to comment.

Justin Perras, a spokesman for JPMorgan, the biggest underwriter of corporate bonds globally, also declined to comment, as did Brandon Ashcraft of Barclays Plc and Zia Ahmed of Charlotte, North Carolina-based Bank of America Corp., the second- and third-largest underwriters. Michael DuVally, a spokesman for Goldman Sachs, also declined to comment.

Shut Out

Smaller money managers such as Elswick at Frost have found it more difficult to win allocations. The firm, which Elswick said consistently bids for $10 million slices of high-yield bond offerings, has been shut out of at least five transactions in the past month.

Elswick said the firm doesn’t experience the same issues in sales of new asset-backed bonds and other securitized products, where he said the process is more transparent. The firm has responded by padding orders for corporate bonds, or asking for more than wanted, a strategy that several money managers interviewed yesterday agreed was commonplace.

“Outside of corporate bonds, we don’t pad our orders because we want to be completely transparent with the broker-dealers,” he said. “But with the corporate market, where we used to not pad at all, now we pad maybe 75 percent of the time.”

The SEC is investigating the market at a time when demand for higher-yielding debt has never been stronger.

Investors piled into such assets as the Fed held its interest-rate target near zero percent and pumped more than $3 trillion into the financial system to spur a recovery from the worst recession since the Great Depression. Even as the central bank has started slowing its monthly purchases of Treasuries and mortgage-backed securities, investors are still clamoring to buy corporate bonds in the face of an escalating crisis in Ukraine and volatility in emerging-markets currencies.

Yields on corporate bonds globally fell to a record low 3.09 percent last May and were at 3.42 percent yesterday, Bank of America Merrill Lynch index data show. That’s almost two percentage points below the average 5.33 percent during the past two decades.

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