Is Fixed Income Broken?

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Adrian Fitzpatrick, Head of Desk Central Dealing at Kames Capital expresses strong opinions on the current state of fixed income market structure.

What is driving managers into equities?
A lot of it depends on which market you’re looking at. If you look at the European markets, there has always been a high weighting in bonds. There’s never really been the equity culture to the same degree as you have in the UK. Obviously in the UK a lot of it is driven by the insurance companies that have actuaries to dictate where the split between equities and bonds lies. Before these pensions’ time bombs, the safest investments for most people were bonds. However, we are all working on the assumption that bonds are currently completely overvalued, but as long as there’s Quantitative Easing they are going to hold these abnormally low levels of yields.
The other thing is institutions don’t want to stand out from the crowd. If everyone’s in bonds and bonds fall then you are going to fall together. There’s so much short term-ism in the market, you can’t afford to be an outlier for a long period of time and then not be right. I think risk assets now are relatively cheap; you look at the yields on risk assets compared to the yields on government assets, some of the credit assets like high yield are still quite reasonable. The bond markets are over valued , but it’s probably not going to change until the QE bubble bursts.
So the macro economics is feeding into that bubble?
Yes definitely. It’s like we said about the dotcoms: Why are you buying things that are at that level? We all know if you go back historically and look at bond yields in the UK, they should be around 4½/5%. But at the current level, it’s only sustainable as long as the Bank of England and the government are prepared to keep rates abnormally low because of the state of the economy. So can we see that carrying on to 2013? Definitely. (See diagram on next page)
You’ve got the government printing money, so all you have to say is, “Where are you going to put your assets?” Unfortunately in the environment that we are in you just can’t stand that far away from the crowd for a period of time.
What is the main problem with the fixed income market?
Effectively the market is not transparent, unlike the equity markets, which are. In equities you can see commissions, you can see the prices, you can see what gets printed. In the bond market you can’t. Platforms have been around for a long time, the likes of Tradeweb, Market Axess, and Bloomberg Tradebook, etc. These will keep gaining more traction because you can send them multiple requests for quotes and they are creating a virtual marketplace, which the regulators will like.
It’s not uncommon to send a trade down electronically to one of these platforms, and for all the banks to just pass; there’s no obligation to make a price or to make a marketplace. They make the price when it suits them. Personally, having traded multiple asset classes, that, to me, is not a marketplace.
You end up working with the fund manager to try and find the other side of liquidity. It’s such a captive market that effectively sooner or later, there has to be some outlet valve that gives institutions the opportunity elsewhere. Obviously, when you look at equities you had the establishment of crossing networks many years ago, of which Liquidnet and E-Crossnet were forerunners. Now what you are seeing on the bond market, through Blackrock’s Aladdin and UBS PIN, are various other brokers trying to get that same result.
What they are trying to do is encourage the institutional investor to create more of an electronic market. The biggest problem is in equities you have, for example, Vodafone, but in corporate bonds you can have 12 credits for the one stock; therefore it’s very difficult to identify a specific one and find a natural cross against it. So it needs to be a slightly different approach for bonds, just because it is a different discipline. You have different variables in bonds, the spread, which obviously a lot of fund managers work off, and you have the underlying Government bond.
The banks are going through what happened in equities. But equities aggregation is now the key; tools have been created that aggregated across the different dark pools to allow you to send one order to many venues. I think that what is needed is an institutional crossing network similar to Liquidnet. We need to create competition away from the banks. However, this isn’t necessarily all the bank’s fault because they say “we provide the risk and therefore we should be able to choose when we make prices.”
However, the biggest institutions are very close to the banks; they can dictate when they want to trade.
For us as an institution, it becomes incredibly difficult not just sourcing liquidity, but being able to trade out liquidity when we need to, because you are totally at the behest of the investment banks. In equities you can trade by program, by algorithm, you can ask for a risk price. You may not like the price, but the market will always make you a price and you can decide whether you actually want to take it.
In bonds, a broker will send out what’s called an “axe”. The axe is effectively the bond equivalent of the IOI. You’ll phone to follow up on the axe but they can back out. There’s no obligation.
In government bonds, where the electronic systems are more established you can trade more effectively, and it is getting there, but the credit part of the market is just completely arbitrary.
Who is going to drive reform?
It will have to be driven by the regulators, in the UK by the Bank of England, and it has to be driven by institutions. The problem is institutions aren’t members of the market. Institutions don’t have the IT infrastructure or the IT spend to be able to create new platforms unless you are a Blackrock or a Pimco.
In the US they use TRACE, and we need a similar system as we need to establish ways for institutions to understand who is doing what, so you can target business to the broker or investment bank. And if not, there should be some form of platform that allows institutions to cross up against each other.

Is this something the regulator will look at?
I would say that they’ve done equities to death, but obviously we’ve got MiFID II and Basel III and all of these things happening. I think they are realising that equities are pretty transparent. If you look at the FX market, at fixed interest and you look at the P&L of any major investment bank, they do not make money in equities, they make all their money on fixed income and FX. Therefore the reward structure of banks is something you need to look at sooner or later.
I think that there is blurring at the edges across the different asset classes that is forcing change, which is why we are going to see transparency in OTC clearing due to Dodd-Frank. The regulators want to know who’s got the positions and therefore where the stresses in the system are.
Most regulators are driven by their governments. Effectively they are trying to force an unbundling of the equity marketplace, through the back door, because you can apply far more pressure to an institution than you can to a broker.
The nature of the bond market has to change from where it is. Sooner or later the regulators will realise that and they will try and create some form of exchange, which is what the platforms provide. But the problem is that there is no obligation to make prices.
Because I trade multi-asset, I can see the strengths and weaknesses of different asset classes. I want a level playing field. In the bond markets it’s skewed towards investment bank that can pick and choose whether they choose to make a market or not, whether they want to honour their axes.
Some things like algos are far more difficult because there is no depth to the bond market, there is no centralised pot of liquidity that you can trade against.
A crossing network solution which gives another option for institutions would bring in spreads and potentially create additional liquidity as opposed to the investment bank, and if they start missing out on business I’m sure they will be more competitive and they will want to get involved.
Do you think reform is going to be driven out of Europe and the UK or the US?
The US is slowly getting there, because they’ve got TRACE so you can see what’s going on. In the European market we are less liquid and therefore it becomes more difficult. There are some products that will aggregate trades across the different platforms starting to become more established which will help in providing depth to the bond markets.
It’s all about providing flexibility, depth and transparency to the market. If you can actually do that, then the regulators, governments, institutions are all happier. You can see what’s going on.
I think the problem is that a lot of these houses only trade bonds, and don’t realise that sooner or later regulation is going to change the market place that they are in.
What shouldn’t fixed income learn from equities?
Equities have gone full circle, whereby the end investor, who is effectively the man on the street, is totally disadvantaged. The exchanges now only care about the bottom line, which is their P&L, and they don’t care if this is from a high frequency trader or anyone else, and the reason for that is institutions are not members of exchanges. We are so far down the hierarchy no one cares about us.
The example I always give to people; if you take Vodafone which was the most liquid stock in the UK prior to the Lehman crisis. As an institution I could trade 25 million shares on the touch. Now if I look at Vodafone, Vodafone’s touch price is barely 36,000 on one side and 65,000 on the other side. I’m sorry that is not a market that is helping the institutional long term investor.
How I could trade Vodafone before, and how I trade Vodafone now, I don’t care that it has a narrower spread, because it’s not about spread, it’s about depth to the market.
Equities are not profitable and the bond markets are hugely profitable but I suspect that regulators and Governments will not allow that to continue.
But the way it is just now; the bulge bracket equity model is broken. We are working on a 1970s model and in 2012 and it just doesn’t work.