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BlackRock Urges Changes in ‘Broken’ Corporate Bond Market

BlackRock Inc. has made three attempts in as many years to draw attention to a corporate bond market which it says is “broken” and needs to improve liquidity. So far, the world’s biggest money manager is garnering little support.

Bond investors including DoubleLine Capital LP and LPL Financial Corp. agree with some of BlackRock’s points, while being skeptical of an effort to standardize bonds and new ways of trading them. Bonds are bespoke by nature because economic conditions and a company’s creditworthiness fluctuate, so making the market more homogeneous misses the point, according to Bonnie Baha, director of global developed credit at DoubleLine, which oversees $52 billion.

“This to me is a non-starter, the whole idea we’re being the voice of the industry in calling for reform,” she said in a telephone interview. As a bond investor, she said, “ostensibly your return is capped - you want to get paid back at par. The nature of the beast is idiosyncratic credit risk.”

BlackRock, which manages $4.3 trillion in client assets, in a paper on trading in the corporate debt market said that low interest rates and muted volatility mask the “extent of the breakage” in the market. The firm’s suggested overhaul includes unseating banks as the primary middlemen in the market and shifting transactions to electronic markets. Another solution is reducing complexity by encouraging corporations to issue debt with more standardized terms.

Retaining Stranglehold

Banks have retained their stranglehold on corporate debt trading despite years of effort by some investors to eliminate their oligopoly. The top 10 dealers control more than 90 percent of trading, according to a Sept. 15 report from research firm Greenwich Associates. To BlackRock, the dangers of price gaps and scant liquidity have been masked in a benign, low interest-rate environment, and need to be addressed before market stress returns.

“These reforms would hasten the evolution from today’s outdated market structure to a modernized, ‘fit for purpose’ corporate bond market,’” according to the research paper by a group of six BlackRock managers, including Vice Chairman Barbara Novick and the head of trading, Richie Prager, posted on the New York-based firm’s website yesterday.

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, even as the market has expanded. With their capacity to act as market makers greatly reduced, the old over-the-counter market has been rendered outdated, according to BlackRock.

Pooling Liquidity

BlackRock suggests more venues in which dealers and customers can trade with anyone; increased standardization of new bonds to pool liquidity; revamping the method by which traders offer and accept prices; and promoting behavioral changes for market participants including investors, issuers and underwriters.

While markets are adapting slowly, with growth at smaller dealers and electronic trading platforms, “still a lot more needs to be done given dealers reluctance to participate in markets,” said Anthony Valeri, a market strategist in San Diego with LPL Financial, which manages $415 billion in assets.

The paper expands on ideas from versions published in 2012 and 2013, which highlight the liquidity concerns and suggest more standardization for company bonds, to cut down complexities that make trading them more difficult.

Centralizing Trading

U.S. Securities and Exchange Commission member Daniel M. Gallagher echoed that suggestion last week, saying regulators should standardize corporate-debt issuances to promote centralized trading of bonds.

Regulators and market participants should reduce the share of bond offerings that are “highly differential and bespoke,” he said Sept. 16 in a speech at a financial markets conference in Washington. To help, the SEC may need to alter some of its rules, including removing registration requirements, he said.

Standardization would allow more trading to occur on exchanges and other electronic venues, and would help stabilize markets in periods when investors rush to sell bonds, Gallagher said. The risk posed by investors trying to dump bonds after the Federal Reserve raises interest rates is “percolating right under” the noses of regulators, he said.

BlackRock was one of the first asset managers to attempt to revive bond trading when it created the Aladdin Trading Network, or ATN, in 2012. After volume proved disappointing, it partnered the next year with MarketAxess Holdings Inc. to attract a more diverse group of buyers and sellers.

Self-Serving

As part of that agreement, BlackRock and MarketAxess developed a pricing system, an alert that notifies any investor on the system if an incoming order matches a bond they want to buy or sell, a person familiar with how it works said in November. That could allow two asset managers to trade directly with one another, removing dealers from the more-lucrative role in the transaction.

Bloomberg LP, the parent company of Bloomberg News, competes with MarketAxess in facilitating bond and swap trades between investors and banks, and in providing financial data and news to investors.

“Proposing more electronic trading systems is a bit self-serving given their desire to enter this market,” Valeri said. While he said he’s also “skeptical of a bond exchange developing,” new and different trading methods are “a step in the right direction, as the more that trading can be taken away from the big dealers and dispersed to other market participants, the better.”

No Choice

BlackRock’s envisioned world would require issuers and the investment banks they work through to revamp the way they sell new debt, and corporate chief financial officers would be giving up flexibility, according to Brian Jacobsen, who helps oversee $232 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin.

In a market where financing is cheap and investors are happy to snap up record amounts of new bonds, companies have little incentive to change the way it works now, said Jacobsen.

Investors “don’t really have much of a choice” about the current structure, according to David Schawel, a money manager at Square 1 Bank in Durham, North Carolina.

“Even though the dealers don’t have the inventory they once had you’re still forced to go through them particularly on non standardized securities,” he said. “Standardizing something isn’t easy, and even if they do something needs to happen to spur adoption. Old habits don’t die quickly. Maybe it will take a liquidity crisis in the bond market for it to really get traction.”

(Updates to add industry reaction beginning in first paragraph.)
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