This past summer, as investors worried about Greece and its possible exit from the euro, slowing growth in China and rising interest rates, Joseph Higgins, lead portfolio manager for TIAA-CREF’s core bond fund, got a call from a trader on the asset-backed-securities desk of a major bank, asking if he was interested in a large block of securitized receivables issued by a leading U.S. finance company. The bank didn’t have the bonds in its inventory. In the wake of the financial crisis, regulators had enacted hundreds of pages of rules to rein in banks, reducing their risk taking but cutting into a central role they had played for decades: making markets in fixed-income securities. The trader was calling on behalf of a hedge fund that wanted to unload the $80 million position amid the market’s swings.
Higgins was very interested — and willing to pay the bank a small fee for playing middleman. After all, $869 billion-in-assets TIAA-CREF, whose awkward acronym belies sophisticated investing capabilities that include fixed income, real estate and energy, had been preparing to take advantage of the changing market structure for years. Since the 2008–’09 financial crisis, the New York–based firm had hired a couple dozen veteran analysts and traders to provide insights and market color that the banks once gave for free. “Where the Street used to call us, we’re now using them as a conduit to securities,” says Higgins, who has spent his entire 20-year finance career in fixed income at TIAA-CREF.
Investors such as TIAA-CREF, one of the ten largest bond shops in the U.S., are at the epicenter of an unfolding drama in fixed income, particularly in the $8.1 trillion corporate-debt market. Business as usual has come to a halt, with a new and yet-to-be-determined set of winners and losers. Many asset managers, including credit hedge funds, hope to profit from cracks in an outdated system that arose in a wildly different era. Others believe those potential returns are a sure sign that inefficient debt capital markets will eventually claim many losers, including companies that need ready access to financing to grow and smaller asset managers that cannot afford to invest in expensive systems and traders. What is clear is that everything is changing, from the way investors manage their bond portfolios to how securities get priced to who picks up the phone first with an investment idea. As power has shifted from Wall Street to the asset management industry, new players have emerged, including electronic market makers, which have already transformed the equity world.
The bond market machine, which evolved over decades, with big dealers and investment banks powering its engine, is broken. Global regulators crippled it when they imposed new rules, such as increased capital requirements and an end to proprietary trading, to prevent a repeat of the financial crisis. Bond trading had been largely impervious to change for generations, but new regulations and technology advances are conspiring to alter the way fixed-income assets change hands.
In an age when companies like Amazon.com and Uber Technologies have triggered a top-to-bottom reordering of their industries and stock trading is barely recognizable from 20 years ago, it’s surprising how untouched some parts of fixed-income markets have remained. Money managers and institutional investors still generally pick up the phone and start negotiations with a handful of banks when they want to sell big blocks of high-yield or investment-grade bonds. Before the crisis a trade could be completed with one phone call, even though most investors shopped around for better prices with a few more brokers. Flush with leverage — borrowed money — banks held plenty of bonds to offer them. With capital now precious, however, these same institutions have pulled back from fixed-income trading, leaving the bond market structure showing its age and investors evaluating a range of solutions.
“Liquidity stinks,” says Daniel Fuss, longtime portfolio manager of the $20 billion Loomis Sayles Bond Fund, referring to the ease with which fixed-income securities can be bought or sold without affecting their price. Vibrant and liquid markets have a deep supply of buyers and sellers, all of whom know where to meet and have an efficient mechanism for transferring assets between them — something that has been lost, says Fuss, as many bank traders have either been let go or have too little capital.
“It takes longer to connect real buyers and sellers,” says Scott Mather, CIO of U.S. core fixed-income strategies for Newport Beach, California–based Pacific Investment Management Co., the world’s largest bond manager. “If people are in a hurry, transaction costs will go up.”
The unprecedented monetary policies by the Federal Reserve and other central banks — which have kept interest rates near zero since the financial crisis — have contributed to the problems. Investors have developed an almost limitless appetite for securities yielding more than Treasuries, such as bank loans and junk bonds. Individual investors, not known for their patience in a crisis, now own 23 percent of the U.S. high-yield bond market through exchange-traded funds (ETFs) and traditional mutual funds, up from 15 percent in 2006. Although fund companies like Fidelity Investments have benefited from the influx of new money, many are nervously waiting for the asset flows to reverse when rate hikes come and investors experience losses. Although bonds historically have been the world’s most boring securities — purchasers are only promised their money back plus interest for their trouble — many investors don’t understand them. When interest rates rise, existing bonds fall in price because investors can turn them in for ones that offer higher payments. Alarm bells are ringing that a lack of sufficient liquidity could even set off another credit crisis.
Richard Prager, head of trading and liquidity strategies at BlackRock, the largest asset manager in the world, with $4.3 trillion, is unequivocal in his belief that bond infrastructure needs to change. “Regulators have been clear about what they want — less risky banks — and yet we still have a market structure that is dependent on them,” he says. “The plumbing is antiquated.” After the financial crisis BlackRock started to expand its electronic trading capabilities and connected its Aladdin trading network, used by both BlackRock and other money managers, to more liquidity pools.
The firm has been pitching its fixed-income ETFs, which can provide investors with exposure to different market sectors without requiring them to enter the underlying bond markets, as part of the solution to the liquidity issue. BlackRock has been harshly criticized for its ETF initiative, however. Activist investor Carl Icahn contends that the firm’s ETFs are contributing to the liquidity problems as investors get lulled into thinking they can get into and out of securities like junk bonds at will, even though primary markets for the bonds are moving in slow motion.
Prager, who headed trading for several Wall Street banks, including Bank of America Corp., before joining BlackRock in 2008, has been relentless in calling for the whole industry to change. He’s a big proponent of an all-to-all protocol, which allows money managers to connect with one another without a middleman (a dealer then provides the clearing). The concept is simple: If banks can’t do a trade, find a direct route.
Prager emphasizes that capital has simply shifted from dealers, which used borrowed money to stockpile bonds, to the buy side. “There’s plenty of capital,” he says. “It’s just not all at the banks. It’s increasingly with money managers and investors. The issue is how to transact in a more frictionless way.” The market has to develop new ways to match buyers with sellers.
Although there is a shrill chorus today about the lack of liquidity, the bond markets never worked all that smoothly, because there is no central exchange for them. Companies issue bonds constantly, all of them unique. The investment banks that helped companies bring the bonds to the market in the first place also control secondary trading. High-yield-bond guru Martin Fridson, who spent two decades at Merrill Lynch & Co., Morgan Stanley and Salomon Brothers and is now CIO of New York–based Lehmann Livian Fridson Advisors, says bond dealers are often compared to market makers, or specialists, on the New York Stock Exchange, who simultaneously offer to buy and sell a particular stock and are required to step in during times of stress.
“People imagine that these corporate-bond dealers have an obligation to stabilize the market,” Fridson explains. “That’s never been the case in fixed income. There is a mistaken notion that in some past era dealers lost money to prevent the market from going under.”
As banks have reined in trading, newer players like KCG Holdings, created through the merger of broker-dealer Knight Capital Group and high-frequency-trading pioneer Getco, and hedge fund firm Citadel have tried to fill the void. Insurance companies, credit hedge funds and other institutional investors also have picked up some of the slack. Michael Vranos, who co-founded hedge fund firm Ellington Management Group in the mid-1990s after running the mortgage desk at Kidder, Peabody & Co., clarifies that his firm isn’t explicitly making markets in securities — buying and selling on demand. Instead, it is purchasing attractive securities from investors who need to sell them quickly and in turn trying to sell comparable positions from its own portfolios soon afterward. Vranos thinks the buying and selling is good discipline for his firm, providing a feel for real, as opposed to theoretical, prices in the current markets. “People complain that liquidity is bad, but what they’re really complaining about is the bid being five points lower than what they want,” he says. “We’re more realistic about where true clearing levels are, so we’re happy to get in the middle of that.”
U.S. Treasuries, thought to be the most liquid in the world, have not been immune to market structure problems. For no apparent reason, in less than an hour on October 15, 2014, the yield on the ten-year Treasury note plunged by more than 30 basis points, a 15 percent move, only to rebound to near where it started by the end of the day. In a July report the Treasury Department and other government agencies couldn’t pinpoint a single cause of the flash crash but concluded that changing banking regulations contributed to the price gyrations.
Regulators and other officials are keeping a close watch over the bond markets. Last month the Securities and Exchange Commission proposed that fund companies develop formal plans to manage liquidity for both open-end mutual funds and ETFs, and document how long it would take them to sell different types of assets, among other measures. The Fed, the Treasury and the International Monetary Fund are concerned that asset managers may contribute to systemic risks and have called for greater scrutiny.
There are bright spots in fixed income. Postcrisis regulations forced over-the-counter derivatives contracts to be standardized and centrally cleared. Banks initially fought the new rules, but now money managers and investors are trading interest rate swaps electronically, and the market has been operating smoothly for a year.
Liquidity, however, is only the highest-profile symptom of the monumental shift that is occurring on Wall Street — which students of the market, like TIAA-CREF’s Higgins, find fascinating. Higgins today works closer than ever with colleagues managing other asset classes to get a better handle on the liquidity of specific securities at any point in time; this involves as much art as science, he says. Recently, he’s purchased additional agency mortgages, which he feels are quite liquid, as a buffer against having to sell more thinly traded corporate bonds in a crisis. Higgins says 2008 taught him that markets can turn quickly and be a dead end for pricing information. He now has alternate sources for determining value, including TIAA-CREF’s own risk models and credit analysis. “Illiquidity can create a situation where there is no valid arbiter of worth,” he says.
After spending three years on active duty in the Navy, Dan Fuss joined Wauwatosa State Bank in Milwaukee, three blocks from where he grew up. It was 1958, and he and the president of the bank would have daily discussions about every bond the bank held — a skill that in the years to come would set him apart from managers who relied on rating agencies for their analysis. The market for government and municipal bonds was well developed, but public markets for corporate issues were still small. Commercial banks, separate from investment banks under the Glass-Steagall Act, dominated the origination of private deals for companies wanting debt financing, placing the paper with insurance companies and other banks. There were few mutual fund buyers.
By the time the Employee Retirement Income Security Act was enacted in 1974, Fuss had moved to Boston Co., ultimately managing a $500 million bond portfolio. ERISA, which was designed to ensure that pensions were well funded, changed everything for the bond markets. Public plans and some corporate funds started pouring money into stocks and bonds to meet the promises they had made to future retirees. Asset managers raced to get in on the action.
Fuss joined Loomis, Sayles & Co. in 1976, as the secondary market for corporate bonds was developing and as managers were devising some of the first active strategies to deal with trends like rising interest rates. Investment banks, which were still partnerships, facilitated secondary trading by standing in the middle and taking a fee every time bond buyers swapped securities. The partners were loath to risk too much of their own money to buy bond inventory. In September 1981, after Fed chairman Paul Volcker declared war on inflation, bond prices hit their low. Interest rates started their long decline and bonds boomed.
Through the 1980s, with the development of the high-yield market, and the 1990s, when structured products like mortgage-backed securities (MBSs) took off, the system and technology were the same: the telephone. As the investment banks went public, they got access to permanent capital and borrowed funds to maintain huge inventories of corporate bonds, making money not only by facilitating transactions but on the difference between what they paid for a bond and its sale price to a client — what today is thought of as proprietary trading. Many asset managers became dependent on banks not only for trading but for all the services around that, including market intelligence, and cumbersome operations like compliance checks and splitting up block trades among multiple separate accounts.
Before the crisis Fuss and his team kept in touch with about 50 traders for investment-grade bonds alone. That number is now 30 at best. Today some experienced traders get what Fuss calls a smidgen of balance sheet, while younger traders mostly service clients on new issues, the banks’ bread-and-butter business. The banks may support new issues in the market for a few weeks, while older issues start to get stranded. When Fuss calls a bank now, the trader may buy only $10 million or $20 million of a $50 million position.
In some ways, hedge funds and other large asset managers are the new bank inventory. What banks used to do in proprietary trading, hedge funds have eagerly taken over. Credit hedge funds see an opportunity to provide liquidity when markets become dysfunctional. Apollo Global Management, Blackstone’s GSO Capital Partners, KKR & Co. and others have raised billions of dollars from institutional investors for distressed and other fixed-income funds. However, hedge funds’ mandates are to make good investment decisions, not to support fair and open markets or engage in the turnover that banks once did.
There’s also public perception to worry about. Even though banks were always profiting from individual investors panicking and selling assets, hedge funds may take a public beating for doing the same. Nonetheless, they are huge players and will likely step in as buyers of last resort during periods of market turbulence.
Electronic trading is also aiding investors, by allowing managers to access new sources of liquidity, particularly for small transactions. Banks may have supported easy trading previously, but they also locked out potential competitors. Now smaller brokers — many of them spun off from the large dealers — advisers for high-net-worth individuals and others are buying and selling bonds on electronic networks. Hedge funds are also active on these platforms.
E-trading, which not surprisingly got its start in the dot-com era of the late 1990s, first automated the phone call, putting investors in touch with multiple dealers instantly. But adoption, particularly for corporate bonds, was slow before the financial crisis. Now, however, multiple start-ups and existing firms see their opportunity and are vying for a piece of the action. They include New York–based Tradeweb Markets, owned by banks and a leader in interest rate swaps, which has launched a platform for corporate bonds, and broker-dealers Liquidnet Holdings and ITG, both of which have long operated big electronic trading systems in the equity markets.
One of the dominant electronic players is MarketAxess Holdings. This year the New York–based company, which was developed by JPMorgan Chase & Co.’s LabMorgan in 2000 and is now publicly traded, posted record revenue, even though most transactions on its trading network are under $5 million. The MarketAxess platform mirrors the physical world, which puts dealers at the center. Investors send what are known as requests for quotes to multiple dealers when they want to buy or sell.
A lot of MarketAxess’ recent success has come from its all-to-all platform. Open Trading, a joint venture with BlackRock, anonymously pools dealers, hedge funds, big investors and others so they can trade with one another. Brokers still clear trades. Though Open Trading hardly sounds revolutionary to anybody who has listed an old jacket on eBay, money managers are not used to being price makers and essentially posting “for sale” signs on some of their holdings. “This does require a big behavioral change on the part of investors and dealers,” says Richard McVey, who was head of fixed-income sales at JPMorgan before becoming CEO of MarketAxess when it was founded. It’s not only that managers are price makers; they also have to implement new systems and hire additional staff to do a lot of dirty work, like reviewing internal compliance requirements so they can lead with a price and not only accept quotes provided by dealers. McVey concedes he was initially skeptical that all-to-all would succeed.
Kathleen Gaffney, who co-managed the Loomis Sayles Bond Fund alongside Fuss before joining Eaton Vance Management as co-director of investment-grade fixed income in 2012, says electronic trading accounts for only 5 to 10 percent of her firm’s corporate-bond transactions, but she notes that it is growing and a great source of still-hard-to-find price information. Unlike in equity markets, there is no live central source for bond prices, only the Trade Reporting and Compliance Engine (TRACE), a regulatory initiative that requires banks to report prices after a trade is completed. Gaffney says Eaton Vance has done some trades directly with other buy-side firms, including emerging-markets debt, and has gotten a much better price than it would have otherwise.
“As a trader you love any source,” says Lynn Parker, a senior fixed-income trader at the Boston-based firm. “And it keeps dealers honest. They have to sharpen their pencils a little more.” McVey himself thinks e-trading may ultimately be effective for only about 30 percent of the market.
There are legitimate reasons that electronic trading isn’t a perfect fit with corporate bonds. Investors still prefer to entrust larger blocks to the big banks. They’re afraid that if they use anonymous electronic pools, information will leak out about what they want to buy or sell and will hurt the prices they get.
One of the biggest hurdles to electronic trading is the nature of the corporate-bond market. When a company gets the itch to issue some bonds, it does just that. Bank of America, for example, has one common stock but 1,066 high-grade bond issues outstanding. Although companies are trying to minimize the amount of interest they pay and reduce their refinancing risk, the constant issuance results in problems for investors. It means that a huge percentage of the total market is brand-new each year.
Investors fall in love with, and pay a premium for, new issues, which switch homes frequently. After four weeks, though, trading volume typically falls by 50 percent. A couple of months later, there is virtually no trading in most bonds, which high-yield guru Fridson says become “museum pieces.” Although many contend that is because the bonds have found a permanent home, it stymies any attempts at efficient trading.
BlackRock’s Prager says corporations need to take some responsibility to ensure there is a well functioning market structure and start doing big benchmark issues that would have more depth and could lower financing costs. Investors wouldn’t have to be paid as much in interest to buy the easier-to-trade issues. In 2013, when Verizon Communications came to market with $49 billion in bonds, one of the largest issues ever, to finance its acquisition of Vodafone Group, investors raced to get a piece of the deal. They knew their chances of finding a buyer for their bonds if they needed to sell would be a lot higher given the billions outstanding.
The idea of standardizing corporate bond issuance isn’t outlandish. Once Treasury started issuing a consistent amount of government debt at predictable times of the year, in the 1970s, U.S. debt started to be used as a core holding, becoming the benchmark for asset markets around the world. “Against all odds — amid high inflation, a falling exchange rate and volatile interest rates — the dollar got locked in as the reserve currency and U.S. treasuries as the preeminent reserve asset,” explains former Treasury undersecretary for U.S. finance Peter Fisher, who now teaches at Dartmouth College’s Tuck School of Business in Hanover, New Hampshire. “Regular and predictable issuance made it possible for investors to hedge their holdings in myriad ways and the government to capture a liquidity premium,” adds Fisher, a senior director at the BlackRock Investment Institute.
But there are barriers to standardization. All those quirky bond issues are a big source of profits for the banks and a stream of potentially lucrative investments for money managers. Standardization and electronic trading together can cut into many investment managers’ returns. Anupam Damani, co–portfolio manager of TIAA-CREF’s emerging-markets bond fund, says electronic trading simply saves her time. The art of negotiation, via a phone call to a human being, yields returns. “Right now there is nothing in e-trading that we would view as alpha generating,” Damani says.
The fixed-income market is still complex, and those who understand it are eager to fill the structural gap. Like many credit hedge fund principals, David Warren, founder of DW Partners, knows these markets well, having spent his early career in banking. After leaving Morgan Stanley in 2007, Warren built the fundamental credit team at London-based Brevan Howard Capital Management in 2008. A year later, he formed DW Partners with Brevan Howard’s backing. The firm’s sweet spot is buying bonds that are trading at 60 cents on the dollar and dealing in residential- and commercial-mortgage-backed securities that others might not touch because of their hard-to-understand structures and investments in other complex instruments.
Warren’s New York–based firm has benefited from the huge growth in high-yield mutual funds in recent years. These funds, Warren explains, may love a particular bond when it is newly issued, but they can’t own it if it becomes troubled. That’s where hedge funds like his step in.
Warren says his firm tries to be intellectually honest about a security’s liquidity from the start: “We think you have to carefully consider liquidity when sizing fixed-income positions. It can be a double-edged sword, though. Bonds can fall more than they might have in, say, 2006, but that can be an opportunity to buy as well.” The debt of energy companies, for example, recently fell far more than models would have predicted. When oil dropped 15 percent, the prices of many bonds dropped twice as much. As securities get more complex and troubled, the world of potential buyers shrinks. “Why? Because it becomes like game theory, trying to understand things like the different layers of debt and the potentially conflicting interests of the various stakeholders,” he adds.
Liquidity and market structure are front and center for Ellington’s Vranos, whose hedge funds invest in structured credit, including legacy residential MBSs, commercial MBSs and collateralized loan obligations. The Old Greenwich, Connecticut–based firm also shorts high-yield indexes to hedge credit risk.
Vranos stresses that investors’ time frames — how long they’ll commit their money — determine a lot about liquidity in the markets. If hedge funds are investing in securities that need to be held for several years before they pay off but their investors can redeem their shares quarterly, there’s a liquidity mismatch. “Think of the capital structure of a hedge fund like a tower,” he explains. “The bottom is the equity — your investors — and the top is short-term loans. When you pull out something from the bottom, it’s a big deal.” Vranos is constantly assessing the liquidity of his positions to take advantage of what’s happening in the market.
For today’s bond market, Sunshine might be the best medicine. No one knows that better than Stephen Daffron, CEO of Bedford, Massachusetts–based Interactive Data Corp. Before starting his finance career, he taught at West Point, the U.S. Military Academy, where he researched the economics of arms financing. He later worked for the Reagan administration and had a front-row seat for the Iran-Contra affair, which used the profits made from secretly selling arms to Iran to fund Nicaraguan rebels.
Bond pricing has always been a giant mystery in the industry, even if it’s not a scandal. There are good reasons for this. Some issues rarely trade, so a price paid months ago may have little bearing on what an investor could get today. Daffron, a charismatic man with four Yale University degrees who worked in fixed income at such firms as Goldman, Sachs & Co. and James Simons’ Renaissance Technologies, thinks transparent pricing would go a long way toward curing the industry’s ills.
Interactive Data has long made a business out of providing end-of-day evaluated bond prices based on a wide range of data from dealers, money managers, regulatory agencies and others. Among other things, those prices are used to generate net asset values for mutual funds. Daffron says his firm’s process is based in part on collecting “exhaust” from places like trading desks: essentially, everything a bank knows about a bond.
He is now overseeing the rollout of streaming prices, which are the product of both computer algorithms and staffers who intervene when information looks out of whack. Mathematical algorithms alone can’t make sense of bond data yet. “Even with the massive amount of data we have, if you feed that into a machine and trust the machine, you’ll screw it up some of the time,” Daffron says. His firm has an evaluation team of 200 staffers, some of whom determine whether to include outlier prices: Maybe a high price was paid by an investor who was shafted by a dealer, or maybe it was paid for a legitimate reason.
To Daffron the availability of real-time prices will calm stressed markets, particularly with fewer banks involved. If investors can’t sell their bonds right away and don’t know exactly what they’re worth, their prices will reflect that and fall further, fueling more chaos. But if prices are available, investors may wait it out and plan a strategy to sell over time. “I’m a Pollyanna,” says Daffron. “We can do a lot of good by bringing transparency, because the people who get screwed are little investors.”
No one knows how markets will function in a crisis, but most bond managers aren’t waiting around to find out. PIMCO has long had traders and research analysts working alongside portfolio managers. The setup gives it instantaneous information about the market. PIMCO’s Mather emphasizes that he knows as much about a security’s price as any dealer would, as well as what information would cause him to increase a bid or reduce an offer to make a transaction happen. “We believe markets will clear,” he says, adding that investors are adapting to today’s markets by correctly pricing less liquid securities that may be more difficult and expensive to trade, including longer-maturity corporates.
Colin Robertson, head of fixed income for Northern Trust Asset Management, who oversees the firm’s $345 billion in fixed income, is positioning his funds so he doesn’t have to be forced into selling in a down market. He holds more Treasuries than he would have in the past, and he’s constantly trading into newer bond issues, which are more easily sold in times of stress.
Even as banks pull back from almost every product line, they’re still protecting their central roles and are not throwing open the doors to new liquidity providers and electronic market makers like Citadel and KCG. Citadel founder and CEO Kenneth Griffin asserted in the Wall Street Journal this summer that the Dodd-Frank Wall Street Reform and Consumer Protection Act’s rules on swaps, which require them to be traded in fair markets with impartial access, should be extended to all parts of the fixed-income markets, including corporate bonds. Because of Dodd-Frank, swaps now trade on what are called swap execution facilities, where nonbank market makers like Citadel are freely participating. Last year the firm’s Citadel Securities group hired former UBS executive Paul Hamill to head fixed income, currencies and commodities. Hamill has been tasked with building out the unit’s fixed-income market-making franchise, including corporate credit, currencies, European government bonds, interest rate swaps and Treasuries.
The industry, however, thinks it has seen this movie before. Since the mid-1990s a combination of regulation, technology and the rise of new market makers like high frequency traders has caused an upheaval in equity markets. Yes, markets are more liquid, competitive and transparent, but many participants argue that investors don’t always benefit.
The classic high frequency trading model has limits in fixed income because the market has a low rate of turnover — not very high frequency at all — and is not transparent. High frequency traders like KCG generally trade a lot during the day but don’t always carry balances overnight. (Jersey City, New Jersey–based KCG has a nascent corporate-bond market-making operation.) To get more involved in fixed income, nonbank liquidity providers need to think more about the risk of inventory and the inability to get out of positions on the same day. That’s the same issue banks are now struggling with.
Investors tend to think a stock, bond or more esoteric product has immutable traits. But in fixed income the way securities are bought and sold has had much to do with their historical returns and ability to provide stability. The behavior of investors — many of whom held the securities to maturity — also added ballast to the market.
Already, bond fund managers have been racing to reinvent themselves and figure out how to make money in a world of paltry yields now that a 30-year bull market in fixed income has run its course. Unconstrained bond funds, which have flexible mandates to roam the world for opportunities and take advantage of market structure changes to buy more-illiquid assets, have become popular offerings, as have credit hedge funds.
But Interactive Data’s Daffron thinks investors will do the opposite. To avoid the market’s vagaries, he contends, they’ll turn to indexed fixed-income products, which can be assembled more easily and are traded less frequently than actively managed funds. “The Bill Grosses of the world will become an anachronism,” he asserts, referring to the world’s best-known bond manager, who famously bolted from PIMCO a year ago to join much smaller Janus Capital Group.
Trading protocols may dramatically change the nature of a plain-vanilla bond fund. If all-to-all takes off — meaning money managers start trading with one another — bond managers may be able to turn over their portfolios at a much lower cost.
Robert Hedges, a consultant on market structure and technology who spent ten years at UBS, including a stint in the futures and options department, says hedging instruments will likely develop further to help banks better manage their capital and investors manage risk without having to go into underlying markets. He thinks new initiatives to improve credit default swap indexes and single-name ETF-style trusts hold promise.
No one wants to see Wall Street go away entirely. “I have no problem with the Street making some money for providing a market-making service,” says TIAA-CREF’s Higgins. “As a firm we respect disclosure, but it’s multifaceted.”
Even those who smell opportunity believe banks should be better supported to ensure healthy capital markets for the long term. Some market participants back proposals that will allow banks to delay public reporting of prices and trade sizes for corporate and agency bonds through TRACE. Banks say the current disclosure requirements increase their risks by broadcasting their trading books, including prices, to the market. “Despite everyone’s best efforts and a true belief that the transparency TRACE created would improve market liquidity, sadly, for many totally unrelated reasons, liquidity today is not better than it was pre-TRACE,” says DW Partners’ Warren, who was chairman of the Bond Market Association at the time TRACE was implemented.
Many investors believe the future will still have Wall Street at its center. Loomis Sayles’ Fuss says he’s been tempted numerous times in his career to think that difficult patches spelled the end of organized markets. “It’s like raising teenagers,” he explains. “For 13 years they’re civilized, then you think, ‘What have I done wrong?’ and then at some point they get better.” He expects markets to improve through a combination of electronic trading and banks eventually being able to carry more inventory for clients. “Markets are going through one of their periodic episodes of being a teenager,” he adds. •