Last updated: June 19, 2012 9:53 pm

Finance: Grinding to a halt

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America’s $8tn corporate debt market faces a liquidity drought as banks retreat from the trade
US economy

On an overcast Wednesday morning last month, Boston’s leading asset managers called nine of Wall Street’s top banks to an emergency meeting in a skyscraper overlooking the city’s harbour.

Over back-to-back discussions – with a hurried lunch of sandwiches and biscuits – they tried to tackle one of the toughest problems confronting financiers and, potentially, the broader economy: America’s $8tn corporate debt market is running out of its lifeblood – liquidity.



To outsiders, this may seem a problem confined to the rarefied atmosphere of a swanky conference room on the 36th floor of Boston’s State Street Financial Center.

But if this liquidity crunch intensifies, some companies already battling a global downturn could find they will also face increasing costs in raising funds. This could then dampen growth in a US economy that appears once again to be straining to recover.

“Corporates face the risk of higher borrowing costs if liquidity continues declining,” says Andrew Lo, a professor at Massachusetts Institute of Technology.

So far, the problem has not spilled into the real economy. In fact, some of the biggest names in US business – IBM, Procter & Gamble and Walt Disney – have successfully borrowed billions of dollars at record low costs this year by selling bonds.

However, this robust picture could change if prominent Wall Street institutions cannot resolve an impasse that has stalled the corporate debt market.

The problem centres on large investment and asset management companies, known as the “buy-side”. These are flush with cash and have sought to expand their massive portfolios with corporate debt. However, they are finding it harder to purchase or sell bonds from “dealer” banks that act as the middlemen, the so-called “sell-side”.

If investment funds have to spend more to trade, they could ultimately pass on their increased costs to companies whose debt they buy.

The banks cannot satisfy the buyside’s needs because they are reducing their own holdings of corporate bonds, partly because of a raft of new regulations proposed in the wake of the financial crisis.

These rules are already altering the way banks behave. While tougher capital standards under Basel III and the pending Volcker rule seek to avoid another meltdown in the banking system, they have had the unintended consequence of sucking liquidity out of the corporate debt market. If banks want to hold riskier assets – such as corporate rather than sovereign debt – they have to go to the greater expense of holding more capital to offset those investments.

From cars to casinos: businesses built on bonds

Bonds are central to the financing of corporate America. Businesses from Microsoft, the software company, and Amgen, the biotechnology group, to Ford Motor and Caesars Entertainment, the casino manager, use corporate bonds to raise the money they need to fund acquisitions, internal development, leveraged buyouts, pension plans and even buy back their own stock, writes Nicole Bullock.

One of the attractions of bonds for such companies is that they offer a means to raise money without diluting their equity base. They also get tax breaks on the interest expense. Over the years, the corporate bond market also has become increasingly accessible to a broader range of companies, particularly smaller and more speculative groups. Recently companies have also taken advantage of historically low rates to refinance their short-term debt and lock in cheap long-term financing with bonds.

Annual issuance of both highly rated corporate debt and junk bonds in the US has doubled over the past decade from less than $500bn in 2000 to more than $1tn last year, according to Dealogic, a data provider.

Since the financial crisis, “corporates” have also been an increasingly popular destination for investors. Hit by big stock market losses, pension funds, money managers and private investors have all flocked to corporate bonds in the hope of a less volatile alternative to equities but a more high-yielding one to government bonds.

Net assets in funds that buy corporate and junk bonds has risen from about $400bn in 2006 to more than $700bn now, according to the Investment Company Institute, an industry body.

For investors, corporate bonds are higher in a company’s capital structure than common stock. That puts them ahead of equity holders in the pecking order of payments in a worst-case scenario of a company going bankrupt.

However, various things can erode the value of corporate bonds. A slowing economy can cause investors to worry about the health of companies and their ability to meet bond payments. Interest rates are another factor. The price of bonds moves inversely to their yields, so a rise in interest rates can send the prices of bonds lower.

A robust market for corporate bonds will be key in upcoming years. Standard & Poor’s estimates that nearly $3tn of US debt will be due by the end of 2016 and need to be refinanced. The rating agency recently warned that global volatility could threaten demand, particularly for the debt of low-rated companies and financial institutions seen as the most vulnerable to risk aversion and global economic problems.

As last month’s meeting in Boston ground on, fuelled by a stream of coffees, the delegates realised it would be impossible to forge a silver bullet that could solve their problems at a stroke.

The heavyweight Boston-based investment firms at the meeting included State Street Global Advisors, Columbia Management, Fidelity, Loomis Sayles and Wellington Management. One of the bankers in attendance says the big investors had a repeated, if impractical, refrain: “We want you, the dealers, to find a solution to make it all better.”

The asset managers certainly had grounds to grumble. The top banks have reduced their holdings of bonds to the lowest level since 2002. At about $45bn, this figure had steadily declined from $235bn in 2007, but went into free fall in the second half of 2011.

While top companies can still issue bonds easily, the banks’ increased reluctance to hold inventory is drying out bond trading in the secondary market, where they are traded later.

“Secondary liquidity is very important for lowering the cost of capital for issuers,” says Rick McVey, chief executive at MarketAxess, an electronic platform for trading bonds.

“If liquidity dries up further there is the risk that investors demand a higher premium and it becomes more expensive for companies to issue debt.”

Although the US corporate bond market is estimated at $8tn, its daily trading volume has averaged $18bn so far this year, a low ratio. By comparison, the $10tn US Treasury market has experienced average daily trading volume of $532bn in 2012.

It is this illiquidity that pushed the Boston asset managers to seek a solution from the banks, but the meeting simply represented an initial distress flare. We are probably only at the beginning of what looks likely to be a protracted encounter between the buy-side and sell-side.

Chris Rice, global head of trading at State Street Global Advisors, who attended the meeting, admits any transformation will take time.

“It is a conversation that will evolve,” he says.

One banker concedes the initial meeting yielded nothing. “It was really a bit disappointing,” he says.

The asset managers’ need to hold the meeting reflected intense exasperation. Simultaneously, some parties have been considering special computer-based trading platforms, which may or may not involve the banks. But so far there is little sense of what format a solution might take.

Beyond the hurdle of more regulation, the bond market has lost other key players who created liquidity. The demise of in-house proprietary trading desks at the banks, that formerly embraced bets on credit, has hurt liquidity, particularly for large blocks of bonds or those that trade infrequently.

This gap in the market worries asset managers as, historically, only banks could find large amounts of bonds. It does not help that, since the financial crisis, individual investors have sought to plough record amounts of cash into bond funds at the expense of equities. So for asset managers, the decline in Wall Street support is very serious.

The buy-side largely accepts it may not always get the best deal in a bond transaction, but balances that against the needs of dealers, who risk their capital in order to support liquidity of prices. Highly liquid trading prevents bonds splashing into a shallow market and roiling prices to the disadvantage of the parties involved.

“What the sell-side has provided for many years, which is very important, is liquidity, and that liquidity is akin to lubricant in an engine and if you take that away you are going to have problems,” says James Hirschmann, chief executive of Western Asset Management.

It is getting progressively harder for the buyside to find someone willing to undertake the risk of warehousing enough bonds to facilitate orders that are accumulated over days or weeks to avoid upsetting the market.

“The Street has not been a market maker for some time, trading is by appointment,” says Jim Sarni, managing principal at Payden & Rygel.

Although the bond trade is now becoming alarmingly thin, trading volumes have never been particularly robust. Most debt is bought at issuance and then does not regularly trade in the secondary market.

Traders turn to terminals

The somewhat opaque corporate bond market has toyed for the better part of 20 years with how they might use electronic platforms.

Conventionally, deals are done person-to-person over the phone.

Among bankers attending the meeting in Boston were a number with responsibility for electronic trading at their respective firms, an indication of where the future may reside. Some banks have forged ahead with their own electronic bond-trading offerings – seeking an early advantage in the changing market.

UBS has already rolled out the “Price Improvement Network,” or PIN, which sees 30 trades a day on average. Goldman Sachs is working on “GSessions”, while BlackRock, the world’s biggest money manager, has taken the unusual step for a buyside firm of proposing its “Aladdin Trading Network”.

All of these platforms seek to match buy and sell orders of the dealer’s clients directly, but are still in their infancy.

The most high profile platform is Aladdin by BlackRock, which dealers see as a competive challenge to their franchises.

“I think that’s going to be resisted by the dealers because they don’t want to see the clients compete against them,” says Fred Ponzo, founder of GreySpark Partners. “They won’t get support from the non-dealers. And without that, it’s going to be harder to get off the ground.”

Incumbents like MarketAxess, which already has a growing business of electronically trading bonds, eagerly wants to be part of the solution, too.

Others are looking to apply technology that draws on super computers and algorithms used by the likes of Google.

Benchmark Solutions, a group of former bankers, developed a continuously self-learning system. Their so-called Market Calibrated Framework calculates fair value for a bond every 10 seconds based on a range of inputs that a bond trader would use in order to make a price to a potential buyer or seller.

“We are showing investors and traders where fair value resides for a specific bond issue,” said Tim Grant, a managing director at Benchmark Solutions and former bond trader at UBS. “Our job is not to tell the market where to trade, just where to start.”

Opportunistic fund managers wrestle with the nature of the bond trade as they want to shuffle their holdings in line with changing markets and interest rates. Such changes require a certain amount of liquidity in the secondary bond market, which is now shrinking further and pushing the buyside to contemplate a future where dealers may play a more limited role in trading.

With the industry searching for an alternative market that can boost bond trading, one difficulty is reaching consensus among a highly competitive group of dealers and investors with different agendas.

One solution that has been considered would be to create an open exchange-like platform where buyers and sellers of bonds could find each other directly, skipping over the traditional middleman role of the banks. However, this appears unlikely to solve all the industry’s woes.

While such platforms dominate the trading of equities, currencies and government bonds, corporate bonds have long been an outlier, with a low percentage of trades transacted on such platforms as MarketAxess, Bloomberg and Tradeweb.

This reflects the staggering number of individual bonds, as the market consists of more than 80,000 separate issues, market participants estimate. Some large companies with big funding needs may have many different bonds outstanding, making trading in this market far more complex than an investor wanting to buy or sell IBM stock. About 5,000 bond issues are estimated to trade actively.

Within this fragmented universe, large investors are sceptical an electronic market can function without a middleman to provide capital.

UBS has already rolled out an electronic trading network but so far it handles only about 30 trades a day. Goldman Sachs, the investment bank, and BlackRock, the world’s biggest money manager, are also working on their own platforms.

Greater electronic trading for corporate bonds is not, however, seen as a panacea for the current problems, partly because the business is so opaque, often conducted person-to-person over the phone. The buy-side is also resistant to electronic trading.

“You don’t want to be too transparent if you are doing a large strategic trade,” says Gavin James, director of portfolio operations for Western Asset Management.

“If you’re trading electronically you are out there, people know.”

This is particularly acute for a market that is increasingly a one-way street, where asset managers are either all buying at one time or all selling at one time.

“There is less diversity in the account base,” says a head trader at a Wall Street bank that attended the Boston meeting. “Now, everyone wants to buy at the same time and sell at the same time. An electronic platform does not fix this.”

Still, among major dealers, there is an acceptance that their stranglehold is ending, leaving a very uncertain future for the corporate bond market.

In fact, the meeting in Boston could even represent an industry considering how best to contend with total transformation or decline.

“You’re living the last few days of the Roman Empire,” says Fred Ponzo, founder of GreySpark Partners, which provides consulting to banks.“It’s actually ended, but there’s still a bit of money to be made. Big dealers will try to milk it until it dies.”

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