The Rise of the Buy Side
Financial rewards for trading are down. Incentives for making markets are gone. And the business of bond trading has been turned on its head.
It’s not Wall Street, where the biggest names in banking stalk the canyons of Manhattan. And it’s not the City of London, where grand financial institutions new and ancient grace the shores of the slate-gray Thames. No, this is Columbus, Ohio, and John McClain, a portfolio manager at Diamond Hill Capital Management, surveys a panorama unlike the traditional citadels of capitalism. From his desk, McClain gazes out at a Tim Hortons fast-food joint and the arena where the NHL’s Blue Jackets play.
Sure, McClain’s office setting is a departure from our accustomed, sepia-toned image of the world of high finance. But so is the way he does business.
Take this anecdote from November.
McClain spotted a seller wanting to part with a chunk of company bonds, which happened to include $2.2 million of notes issued by Rent-A-Center, a company that deals in rent-to-own furniture and electronics. Having spent hours crunching the numbers of the company, based in Plano, Texas, he knew Rent-A-Center was a name he liked; he also knew its bonds didn’t change hands often. Yet here they were, in an odd-size offering packaged with the bonds of a bunch of other companies and being sold by a “transition manager,” which indicated to McClain that the counterparty wanted to move fast.
Before the global financial crisis, a trader at a bank wouldn’t have blinked twice before taking the Rent-A-Center paper on his balance sheet to parcel out as he found buyers. Such a play is as good as dead now, says McClain, 34. If the trader doesn’t have the other side of the deal lined up, the bank isn’t going to stick its neck out.
Indeed, a day after the opportunity presented itself, the Rent-A-Center bonds were still up for grabs. McClain saw just one viable dealer quote, and it proposed buying only a portion of the bonds at their market price. If the seller wanted out completely, McClain reasoned, he could buy them at a discount. So he made his move, bidding for them about 2 cents lower than their trading level—but with the promise to buy all of the Rent-A-Center notes. His offer was accepted on an electronic-trading platform.
That sort of transaction would have been “unthinkable 10 years ago,” says McClain, who succeeded in resetting the price on the notes without interacting with a single Wall Street trader. If he had gone the traditional route through a sell-side dealer, he might have coughed up $50,000 or more on that one trade alone, he estimates. “Now it’s more of a level playing field, as dealers have been pulling their balance sheet and simply crossing trades,” he says. “We have stepped in to provide liquidity.” Having stepped in when someone was discarding the bonds in distress, McClain would have been able to sell them in late July after recording gains in excess of 10 percent.
McClain’s Rent-A-Center play is a stark illustration of an irrevocable shift in the balance of power in the global bond market since the financial crisis: the rise of the buy side. “Before the crisis, it was like everyone was onstage but only the sell side had speaking roles,” says Richard Prager, the New York-based head of trading, liquidity, and investments at BlackRock, the world’s biggest money manager. “Now everyone is speaking up.” Even in Columbus.
The bond dealers and investment banks that make up the sell side were once the lords of fixed-income markets. They would have snapped up that Rent-A-Center paper before McClain had spotted it. Prior to 2008 they maintained large warehouses of bonds and were the first port of call for investors looking to add or offload securities. They also took debt onto their own balance sheets, made bets with their own money, and spearheaded developments in trading and technology.
Today, post-crisis regulations intended to make banks safer and discourage risk-taking are eroding their profits and forcing dealers to rethink their business model. Banks are pulling back from market-making and shedding assets, business units, and employees. The dealer has essentially been demoted from maitre d’—deciding where everyone sits and recommending dishes—to a waiter taking orders. These changes have created a vacuum in the bond market and made trading much trickier.
They’ve also paved the way for the buy side—from asset managers to hedge funds—to exert more influence than ever on the market. Those on the sell side once employed armies of analysts to come up with the smartest trade ideas to make money for themselves and their clients. Not any longer. An ongoing brain drain has left some dealers overstretched, under-resourced, and less able to compete with the buy side. “The banks have fewer resources and less capacity, so the buy side has to be more self-reliant,” says Lior Jassur, who works for the $439 billion investment management firm MFS in London.
A case in point: Just before Christmas last year, Carson Block, a short seller who made his name alleging fraud at Chinese companies, targeted French retailer Casino Guichard-Perrachon and its biggest shareholder, Rallye. In a typically scathing report by his firm, Muddy Waters Research, Block said Casino was using “financial engineering” to mask a “sharply deteriorating core business.” Block’s accusations, which Casino denied, sent both companies’ bonds and stocks tumbling.
Across Europe, banks rushed out commentary and trading ideas. Within hours of Block’s move, Jassur was staring at reams of the stuff. At his desk in the City, which has a view of the U.K.’s tallest building, the Shard, Jassur stayed calm. There was a time, before the financial crisis, when the banks’ credit analysts were imparting gold-plated information. Now banks simply don’t have the analytical firepower they once had.
Jassur, 49, wasn’t surprised to see most analysts following Block’s lead. None recommended buying. And their recommendations didn’t change—even as the bonds lost 13 percent of their value over the next month. Jassur and a colleague did their own analysis. They pored over data, talked to Casino’s staff, and reached their own very different conclusion: Block’s strike had created a buying opportunity.
They were proved right. Casino’s 2026 bonds, which had raised 900 million euros ($1 billion) for the company when they were sold in 2014, fell to a low of 76.3 cents on the euro in mid-January from 87.7 cents on the day Block launched his attack in December. But the bonds recovered that loss by March as Casino sold off assets to improve its finances. By late July they reached a one-year high of 108 cents. (Jassur, citing company policy, declined to comment on any trades MFS may have made in Casino’s bonds.)
All of this matters because the $100 trillion global bond market is an essential part of the machinery that keeps the world’s economies ticking. It provides a place for governments and companies to borrow money and for investors, including pension funds and hedge funds, to buy securities. Today the business has been turned on its head, according to interviews Bloomberg Markets conducted with a dozen buy-side, fixed-income traders at firms that manage a combined $8.5 trillion of assets. Put simply, the buy side rules—and it’s no longer looking to dealers to set the tone of the market or determine its structure.
In the pre-crisis bond market, a money manager with a position to sell would typically ask a handful of dealers for a bid and accept the most competitive one, thus being a price taker. No more, says Brett Chappell, who works in Copenhagen as head of fixed-income trading at Nordea Asset Management, which oversees 202 billion euros. Today, says Chappell, who began his career trading interest rate swaps in Paris in 1990, buy-side traders need to become price makers, especially on less liquid trades, communicating to dealers a specific, take-it-or-leave-it price.
Bond investors should also be able to determine how much they pay to trade with dealers, says Cathy Gibson, head of fixed-income trading for Deutsche Asset Management’s U.K. operations in London. Gibson’s unit has 719 billion euros of assets under management. Before the crisis, it was the norm for banks to take bonds onto their balance sheets for months at a time before selling them back into the market. Today banks act much more like brokers: seeking to match buyers with sellers without assuming any of the credit risk.
Gibson says that as the business model has changed, so too should the pricing. Banks can’t expect to be paid pre-crisis fees for post-crisis business. She gives this example: In a trade where a bank is taking a high-grade corporate bond onto its books, she might be willing to pay a premium of 15 basis points above the bid-ask spread. If the dealer is simply looking to pass on the notes, Gibson says she wouldn’t be willing to pay extra.
For Fabien Oreve, technology-fueled data analysis improves trading relationships. The Frenchman got his first job in finance in 1995 working for a stockbrokerage in Casablanca, where he learned computer programming and database management. Orève is now in Brussels as the global head of trading at Candriam, an investment management firm that oversees about 97 billion euros in assets, and his experience shows just how advances in technology are changing the way buy- and sell-side firms interact.
From electronic-trading platforms to services allowing investors to identify who owns the securities they may wish to trade, the bond market is undergoing a transformation. For the past year, Orève has been collecting data on all of Candriam’s fixed-income trades. The firm crunches the numbers and sends its dealers in London a monthly report detailing how they rank against their peers in terms of volume of business done with the firm across bond sectors. “Both ourselves and our counterparties can exploit the wealth of information in the table to create new business opportunities,” Orève says.
Running the numbers also helps Orève spot quirks in the market. At certain times, dealers are less willing to trade, potentially leaving investors stranded in a trade they wish to exit. Orève noticed, for instance, that every three months, as banks approached their quarterly earnings announcements, they became more reluctant to take on new positions and would widen their average bid-ask spreads to make buying and selling less financially rewarding for investors. “They know we know,” he says—and that can make for improved relationships during those quiet trading periods.
The increasing electronification of the bond market, where many trades are still conducted over the phone, has given investors greater access to information and cut some trading costs. Money managers can now conduct their own analysis of market prices and investor positioning for certain bonds. That, in turn, can help them be better informed when dealing with sell-side players. These advances, together with developing strong relationships in the market, can help buy-side firms become price makers, says Nordea’s Chappell.
Today, from London to New York to Singapore, more than 100 electronic platforms offer fixed-income trading. And venues are cropping up to fill the gap left as banks retreat from the market, making it harder to buy and sell debt. Some, such as Liquidnet Holdings, connect buy-side firms directly with one another, cutting out the dealers altogether. (Bloomberg LP, the parent company of Bloomberg Markets, competes with Liquidnet in providing a venue for electronic trading of corporate debt.)
The banks’ global fixed-income businesses, once among the most lucrative in finance, have been torpedoed by rules imposed after the financial crisis to make banks take on more capital and less risk. Tougher regulations for dealers—including Basel III and the Dodd-Frank financial reform law—have eroded the financial rewards of trading and removed incentives for making markets. Declining revenue has also prompted dealers such as Barclays and Deutsche Bank to cut costs by downsizing and repositioning their businesses.
In the past 12 months, banks, including Credit Suisse, Morgan Stanley, and Nomura, have cut jobs and stopped trading certain products, such as mortgage-backed bonds and distressed debt. Most dealers’ bond desks have been hollowed out; they’re turning over less volume with fewer staff for lower rewards. Revenue from trading in fixed income, currencies, and commodities fell to $70 billion last year at the 12 largest global investment banks, the lowest level since 2008, according to data compiled by Coalition, a financial research firm.
Meanwhile, the number of traders and salespeople at those firms declined by about a third from 2010 to 2015, with 9,000 jobs lost, according to Coalition. The pain is far from over. With higher regulatory costs and record-low interest rates suppressing returns, banks will look to reduce their balance sheets by about an additional 10 percent in the next two years, according to a joint white paper produced by the management consulting firm Oliver Wyman and Morgan Stanley.
The sell side’s retreat from market-making and its shrinking inventory of bonds have coincided with a deluge of bond sales from companies taking advantage of the extremely low borrowing costs to raise funds cheaply. The result has been a rapid expansion of buy-side bond holdings, which has given certain firms greater ability to wrest more influence.
Yet with greater power comes greater scrutiny. As the buy side’s asset pile and prominence burgeon, according to the Oliver Wyman-Morgan Stanley report, asset managers could face the kind of stress tests that banks have endured in the wake of the financial crisis, as well as additional examinations of liquidity risk and financial conduct.
While the buy side has been hurt by the deteriorating trading conditions in the debt markets, caused by market makers’ retrenchment, it has the potential to see a liquidity crisis of its own making. Mutual funds that invest in bonds and allow investors to withdraw their money on a daily basis more than doubled their holdings of U.S. credit in the past decade. Policymakers have warned that the mismatch between debt that can take weeks to sell and funds that offer daily liquidity creates instability and could be dangerous in a market rout.
That’s not the only area of buy-side business that regulators are looking at. The Financial Stability Board, whose members include the U.S. Federal Reserve and the Bank of England, said in June that exchange-traded, mutual, and other funds should have extra oversight to ensure they can sell assets to meet investors’ demands to pull out their money during volatile markets. The FSB also said it may designate certain asset-management companies as systemically important and in need of stricter supervision. BlackRock, with $4.9 trillion in client assets, has lobbied regulators and published reports stating that concerns over funds triggering the next financial crisis are overblown.
Although the equilibrium of the bond market has shifted greatly since the financial crisis, the sell side and the buy side still, to varying degrees, need each other. Investment firms may profit from the demise of the dealers by buying their bonds and hiring their employees, yet for the most part they’re not looking to replace them entirely. “You’ll never do away with the banks, nor will we just wait for them to come up with solutions for problems in the market,” says Deutsche Asset Management’s Gibson.
The buy side will continue to trade with dealers, yet it will also look to exert its influence on the way bonds are transacted, she says. Most money managers aren’t seeking to take on traditional dealer roles, such as becoming market makers, for that runs counter to their primary goal of generating returns for their investors, says BlackRock’s Prager. Even so, they’re becoming more assertive in saying at what price they want to buy and sell a security, rather than being a price taker, he says. “Being a good fiduciary,” Prager says, “means you don’t just sit back and let the market do whatever it does.”
Whether in Columbus or London, toiling away across from a Tim Hortons or in the shadow of the lead-clad dome of St. Paul’s Cathedral, the buy-siders are not sitting back. They’re the bond lords these days.
Marsh covers corporate finance in London. Natarajan covers corporate finance in New York.