A fast-moving evolution is sweeping the bond markets. An unintended but welcome consequence of the convergence of technology, regulatory changes and economics is giving smaller orders a chance at better prices and liquidity. Electronic platforms have thrown open the clubby world of bond trading at last.
Advisors not only need to realize what electronic bond trading platforms can offer them and their clients, their peers say, but they also have to understand the market forces driving their use. For there is a darker side to this good-news story. Industry analysts and principals warn that debt markets on the whole are surprisingly illiquid, shaky enough to grab the attention of the Securities and Exchange Commission. Advisors need to prepare an escape plan now in case interest rates suddenly rise and bond prices drop. Doing so, they say, could limit potential client losses.
“The majority of RIA bond business still is voice driven,” according to David Weiss, a New York-based senior analyst with the Aite Group, a consulting firm. It may be time for RIAs to tell their execution service what they want.
“Bond trading could greatly be improved if better technology was developed,” wrote Martin J. Kossoff, CFP, AIF, in response to an e-mail request. “Compared to trading equities, it seems stuck somewhere around 1989ish,” adds Kossoff, who is president and principal at Sarasota-based RIA Kerkering Barberio Financial Services Inc.
Platforms “could only help, as there is very little price transparency at all, and since so many issues exist that trade by appointment only.” Bonds that often haven't traded in months or years are hard to get bids for or even accurate pricing, he says. “The client thinks the statement price is an accurate representation of what that bond could sell for, but often it’s 10 percent off, or more.”
The technology Kossoff and advisors like him want to see is here, but market factors have kept its use more common for large institutional bond orders. Today's electronic bond platforms can steer orders to crossing networks, auction systems, exchanges, electronic communication networks (ECNs) or alternative trading systems (ATSs) where orders are aggregated, (increasing liquidity) and executed.
After five years using platforms, including New York-based TMC Bonds LLC's system of the same name, Rob Kantor, ARPC, managing partner at the RIA firm XML Financial Group, in Rockville, Md., has seen gains. “We have noticed improvements in pricing,” he told FA-Mag through a series of e-mails. TMC is owned by a consortium of large banks: Bank of America Merrill Lynch, Citi Global Markets, Morgan Stanley, Assured Guaranty and TMC employees.
XML is a customer of LPL Financial, a broker-dealer that channels bids and offers through its proprietary system to TMC. When Kantor wants to buy a bond, he says, he surfs the street for what is out there. If he doesn't like a bid, he'll ask his broker at LPL to check bond prices displayed on the Bloomberg Professional service's “ALLQ” screen. He can buy and sell the bonds directly off TMC's Muni Center screen.
The kind of price discovery Kossoff craves comes with many bond platforms, like UBS's PIN (for Price Improvement Network) and best-execution systems, like BondScope, from Knight Capital Group. BondScope is a module for pre-trade compliance issues that can also verify whether the price paid for a bond was the best available for the client at the time.
Tradeweb Retail, a division of Tradeweb Markets, also is offering best execution on its platform. The company has been positioning itself as “the next-generation electronic marketplace for retail fixed-income trading,” according to a release. It is focusing “greater attention on helping financial advisors and clients with price discovery, security selection and best execution, while adhering to principal business and compliance rules.” In December, Tradeweb inked a deal with Vanguard Brokerage Services that allow Vanguard clients and fixed-income traders to access the Tradeweb Retail platform.
Bloomberg was rumored to have an all out “dog and pony” show to market its ETOMS connectivity system directly to RIAs to execute their bond trades. Analysts say part of the impetus for this was to draw liquidity from RIAs. However, Bloomberg firmly denies it is marketing directly to RIAs, but confirmed that they are marketing ETOMS to retail dealers.
The bond market structure itself is changing. Tier I and II banks don't want to hold large bond inventories; for one, because they add to the banks' government-mandated capital adequacy requirements. At the same time regulatory fiduciary requirements are making dealers back away from their role as principals in transactions, opting instead to aggregate orders among buyers and sellers on systems, which frees the dealer from holding bonds and acting as a counterparty. A drop in bond inventories is reflecting this downturn to $46 billion this year, from $211 billion at the peak of 2007, says Aite's Weiss. The only time bond inventories have been lower was in 2002, when they dropped to $45 billion. Yet new bond issues are plentiful as governments and corporations reissue bonds to gain lower interest rates.
It's a turnaround that small trades are suddenly being courted by the big players. But technology is making it economically feasible for desks to move small and odd lot trades off their books faster. “In the beginning, odd lots were focused on RIAs, now everyone is going into them,” Weiss says. “That's producing more liquidity on the odd lots. It's a follow-on that retail didn't start or initiate, but is profiting from.”
The push for liquidity can be traced by the fall in large block trades from 13 to 8 percent, from 1Q2008 to 1Q2012, according to Will Rhode, principal and director of fixed income-research for Tabb Group. At the same time, odd-lot volumes have doubled, from 6 percent to 12 percent, over the same period, says Rhode. The average trade size in corporate bonds has dropped 37 percent since 2007, even as the number of trades have doubled; again, raising the trade volume of smaller trades.
BondDesk Group is trying to combine institutional and individual or retail orders on one network, says Rhode. Tabb's analysis of the BondDesk platform showed it currently displays two-sided live markets on 5,121 CUSIPS that have offering lots between $100 million and $500 million. “When we looked at the spreads on these CUSIPs, we found 1,321 with a bid-ask spread of less than 10 basis points,” says Rhode. “More than a hundred buy-side institutions are now active on the platform, up from 84 the previous year.”
Some institutional servicers are hesitant to label a product retail, due to the varying size and number of trades under that umbrella: small may mean 250 bonds, odd lots can be under 100, and then there are rarely traded issues. Is it worth executing little odd lots trading at $100,000 to $1 million, when [a servicer's] principal business is in block trades worth $25 million? asks Robert G. Smith III, president, chief Investment officer and principal at Sage Advisory Services Ltd., in Austin.
The average trade size that Sage, which manages $11 billion for institutional and individual clients, would put on Tradeweb runs between 100 to 250 or 350 bonds, at a value of $150,000 to $200,000 or so. “It's not whether you service institutions or individuals so much as how much business you have that's important, transactional flow and how often you bring that business to market,” says Smith.
It follows that some big retail names are sending flow to these platforms. Part of Schwab's retail bond orders flow to BondPoint, where the average trade size in April was $45,000 in bond value, according to Marshall Nicholson, managing director and head of Bondpoint's electronic trading platforms. “Use has been up significantly over the last four or five years, and hit a first quarter record in volume,” says Nicholson. Electronic trades on the BondPoint platform between January 2008 and January 2013 hit a compound annual growth rate of 42 percent.
Smith participated, along with Tabb's Rhode, in an April 16 SEC Fixed Income Roundtable, which is currently taking public comments. Smith's panel looked at “Potential Improvements to the Market Structure for Corporate Bonds and Asset-Backed Securities.”
He says electronic bond platforms give advisors a better shot at getting the best prices for their clients. “But now it's up to advisors to acquire the knowledge of how these markets work – their mechanisms -- how they're driven, and how they may be affected if the bond market reverses.”
Smith shares many of the SEC's concerns, specifically about “the tremendous contraction in the current market system's capacity to hold inventory,” he says. “And, the tremendous contraction in the willingness to act as principal and a preference to act as agent.” The agent model doesn't encourage asset appreciation, since to make agency viable the bonds have to be traded as quickly as possible, rather than held in inventory for a better market opportunity.
Also, mega-sized trades are happening in what Smith calls, “a bond club,” where transactions are arranged weekly by large banks whose trades cross with each other, but often in sizes too small to report to the bond market's version of a ticker, the Trade Reporting And Compliance Engine (TRACE). Add to these private networks the multiple electronic execution systems and you have a fragmented corporate bond market.
The SEC, like the rest of the industry is trying to get ahead of what might happen in scenarios such as a rise in interest rates and a fall in prices among the $11.4 trillion (as of 2010) in bonds outstanding.
One of Smith's colleagues on the SEC Fixed Income Roundtable, Michael A. Goldstein, a PhD and professor of Applied Investments at Babson College and Chair of the Financial Regulatory Authority (FINRA) Economic Advisory Committee presented his research on the risk raised by illiquidity.
Goldstein and his colleague found the number of bonds have risen from 2 billion to 3 billion from 2005 to 2012. But institutional trades for the same period have only grown from under 2 million to under 4 million, while total trades climbed to 11 million.
They studied 47,629 TRACE-eligible bonds over a 1,156 trading days (July 2002 to Januar 2007) and found that 18 percent had no trades. They concluded that “most bonds are highly illiquid.” What's more, the highest number of trades, 30 per day, were among the lowest graded BB, B and CC credit risky bonds. Goldstein sees a pattern between today and “pre-subprime crisis,” when illiquidity rose, and yields spread among the lower-grade bonds while higher-grade issues were held longer.
Says Goldstein, “The five-year Treasury bond has a payoff function like writing a call option – i.e., very risky. For RIAs, right now, bonds are as risky as writing options. And once the bond prices fall, there will likely be additional illiquidity effects as people pull money out of Bond ETFs and the Bond ETFs sell in a market with not a lot of liquidity.”
“People are saying how does risk in the transaction systems work today versus before the economic crisis?” says Smith. “Does every one have the same capacity and same mechanism for everyone to get around this market? And that answer is no. Not everyone gets the same chance.” The evolving bond market model warrants careful review, says Smith, who is leaning toward a single exchange solution. “As an RIA, I want to think about that.”