The good news for bond traders? Fixed income is outperforming stocks. The bad news? High-yield securities are following equities.
By Contributing Editor Jeanne Burke. Assistant Editor Curtis Yoshioka compiled the statistics
November 2000
Institutional Investor Magazine
Early in September the bond traders at Lehman Brothers decided to have a little fun. Having watched for five years as high-technology-driven equities overran the capital markets, generating record brokerage profits and unprecedented media attention for stock traders, investment bankers and analysts, the fixed-income group couldn’t help but take a little pleasure in the stock market’s extended slide and the bond market’s quiet revival. So they hoisted big signs over the trading floor proclaiming, “Bonds are back.”
“We have seen an increase in investor appetite around the globe for fixed-income securities and wanted to make sure that all of our people were energized around that,” explains Jeffrey Vanderbeek, Lehman’s co-head of capital markets. In the interest of accuracy, however, Lehman’s banners should probably say, “Most bonds are back.” Indeed, amid a generally recovering bond market, the high-yield sector is suffering through one of its worst periods ever -- in part because of the same telecommunications and technology companies whose equity shares have been slammed.
Putting aside the high-yield dilemma for a moment, the bond market’s renewed vigor contrasts sharply with the gloomy outlook that pervaded the fixed-income arena only a year ago. New issuance had all but dried up because of Y2K-related concerns late in 1999, and secondary-market trading was subdued at best. U.S. Treasury bonds were becoming ineffective benchmarks as supply dwindled, and the Federal Reserve Board had raised interest rates three times to try to slow an economy fueled by a surging stock market. As if poor market conditions weren’t enough, dot-com mania was hitting close to home: Electronic trading was taking hold, and bond traders, already cashing smaller bonus checks than their equity counterparts, now had to worry about their jobs as well.
Since then new-debt-issue volume and liquidity in most sectors have rebounded, traders have been experimenting with new benchmarks, the central bank has stopped raising rates, and the fear of electronic exchanges has diminished. Sentiment is better. “People are concluding that fixed income is not a business in decline but rather a growth business,” says Thomas Maheras, head of fixed income at Salomon Smith Barney.
It’s also a business where size counts. In the eyes of clients, the biggest global investment banks continue to provide the best service, judging by the results of this year’s Institutional Investor fixed-income trading poll. Salomon Smith Barney takes first place overall for the second year in a row, while Merrill Lynch & Co. and Goldman, Sachs & Co. maintain their rankings of second and third, respectively.
One reason for the stability at the top: Consolidation on Wall Street took a breather during most of the first half of 2000. As a result, no firm was able to leapfrog several places on the strength of a combined operation. The respite was short-lived, however, as UBS Warburg swallowed up PaineWebber; Credit Suisse First Boston absorbed Donaldson, Lufkin & Jenrette and its well-regarded high-yield bond department; and Chase Manhattan reeled in J.P. Morgan about midyear. But none of those deals was announced in time to figure in II’s surveys.
Although the overall market has improved this year, it has had its share of bumps along the way. Before the first month of the millennium ended, the yield curve inverted for the first time in a decade; the U.S. Treasury’s bond buyback program, coupled with the Fed’s tighter monetary policy, caused yields on long-term bonds to fall well below short-term rates. Traditionally seen as a harbinger of recession, the resulting inverted yield curve dampened the tone in the bond market and hurt issuance. A 50-basis-point interest rate hike by the Fed in May, after two 25-basis-point rises in the first quarter, did not help matters, and spreads widened significantly between March and June.
Particularly hard hit was the high-yield bond market, where rising defaults, disappointing earnings, prospects of a weaker economy and mutual fund outflows helped keep spreads at historically wide levels. Telecom and other tech companies, which have issued debt to finance ambitious growth programs, led the whole sector down. Lower-rated telecom securities were off more than 6 percent through mid-October. Dealers were beginning to feel the pinch. Morgan Stanley Dean Witter said markdowns in its high-yield portfolio, thought to be heavy in telecom names, had reduced quarterly earnings by nearly
4 cents a share and would have a similar impact in the current quarter, bringing the total loss to about $90 million. Fear of losses prompted many firms to cut back their exposure to the sector, draining liquidity. Even higher-rated corporate bonds were being negatively affected by late October. “It’s been a tough year” in high yield, says Art Penn, head of global leveraged finance at UBS Warburg.
Elsewhere it’s been a different story since early summer. The Fed held rates steady, spreads in many areas tightened significantly, and returns climbed into solidly positive territory. At the end of the third quarter, the Lehman U.S. aggregate index had returned 7.1 percent year-to-date. Certain sectors, like emerging-markets and long Treasury bonds, were up 12 percent or more, while high-yield bonds were down about 1 percent. The overall returns look more impressive when viewed against stock market performance. In late October the Standard & Poor’s 500 index was down more than 5 percent, and the Nasdaq had declined by more than 15 percent. Individual technology bellwethers, including Microsoft Corp., Amazon.com and Yahoo!, were all off nearly 50 percent or more during the first ten months of 2000. Barring a dramatic reversal, bonds will outperform stocks for the first time since 1990.
If so, it may start a trend. The demand for fixed-income securities should increase -- even from equity types. Many high-net-worth and other individual investors -- some enriched by dot-com options and others by a decadelong bull market -- want to preserve their gains. Armed with lots of fixed-income information gleaned from the Internet, these investors are seeking alternatives to the volatile stock market. “There’s a lot of inquiry,” says Edward D’Alelio, head of core fixed income at Putnam Investments. A rapidly aging population as the postwar generation begins to reach retirement is also expected to favor the current income that bonds produce. “We’re gearing up for a shift and a more sophisticated [investor] approach to fixed income,” D’Alelio adds.
Institutions have already jumped in, largely because overseas investors are attracted to the higher yields in the U.S. compared with those in Europe and Japan. Non-U.S. demand has risen about 10 percent this year, to $175 billion on an annualized basis, and is up 300 percent since 1995, estimates Jack Malvey, chief fixed-income strategist at Lehman Brothers. A
7 or 8 percent return, in light of falling stock prices, is starting to look attractive. “There are early signs that the massive shift away from fixed income has reversed,” says Salomon’s Maheras.
Improving market conditions would undoubtedly help, since uncertainty and change won’t disappear. For example, various fixed-income sectors are now using different benchmarks in place of 30-year U.S. Treasuries, and no marketwide consensus has emerged. Some sectors are using the swap curve, others agency bonds, and still others continue to refer to the U.S. Treasury as a bellwether. Meanwhile, the direction of oil prices, the inflation rate, the value of the euro, the pace of Treasury buybacks under a new administration and the Fed’s postelection interest rate policy are all big questions.
The uncertainties aren’t all market-related. As the Internet has developed, bond trading platforms have proliferated; there are now more than 70, up from only 11 in 1997. About 26 of these are “cross-matching,” bringing dealers and institutional investors together in an anonymous bidding process, according to the Bond Market Association. The big Wall Street firms estimate that last year they conducted about 10 percent of all U.S. government bond trades electronically. That share has climbed to between 40 and 50 percent recently, they say.
Initially wary, Wall Street has warmed to electronic trading in recent months. “The big difference between this year and last is that traders don’t view technology as a threat anymore, but rather as a way of being more efficient,” says Stuart Clenaghan, head of fixed-income e-commerce at UBS Warburg. Low-
margin, commodity-type products, such as Treasuries, and smaller transactions have proved ideal for electronic trading.
Pushing this business onto an electronic platform gives traders, salespeople and analysts more time for bigger, more complex -- and potentially more profitable -- transactions. “People were worried that all the interesting business would migrate away, but in reality, electronic trading allows you to buy milk and bread more cheaply,” explains Stephen Hester, head of fixed income at CSFB. “There is too much complexity in fixed income to commoditize all of it.”
That said, there is still uncertainty over how far electronic trading will extend into fixed income. It will begin moving shortly into the credit sectors, including high-grade and high-yield corporates, through well-supported exchanges, such as BondBook and Market Axess, which are both expected to get off the ground by year-end. “When we look back on it all, I think we’ll see that 2001 was the year that electronic delivery hit its stride,” predicts Lehman’s Vanderbeek.
Until then, bond traders can breathe a little easier as they get more hands-on experience with online systems and more comfortable with their role in the bond market of the future. Some will be cheered just to know that there will be a bond market of the future. As Vanderbeek says, “Reports of the demise of the fixed-income market are more fiction than fact.”
