Buy-side braced for “fundamental” bond market restructure – The TRADE Poll

Institutional investors anticipate a series of changes to their fixed income investment and trading practices as post-crisis reforms threaten to squeeze liquidity, results of's March poll indicate.

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Institutional investors anticipate a series of changes to their fixed income investment and trading practices as post-crisis reforms threaten to squeeze liquidity, results of’s March poll indicate.

When asked how the buy-side would be impacted by a reduction in liquidity in the fixed-income markets in reaction to regulatory change, 30% of respondents said wider spreads would push smaller firms out of the market. A quarter of respondents expected increased pressure on buy-side firms to become price markers and a further 25% said investment institutions would adopt brokers’ liquidity aggregation tools to source fixed income liquidity. Relatively few respondents predicted a shift away from fixed income investment by fund managers: only 20% said reduced liquidity in the fixed income markets would lead to a growth in use of alternative instruments such as exchange-traded funds.

Increased capital requirements under the proposed Basel III regime have forced a number of brokers to quit the fixed income market or severely reduce their inventory as they slim down their balance sheets. Increased competition among trading venues has seen existing bond trading platforms expand their capabilities while a number of new initiatives have been launched. Earlier this week, global exchange operator Nasdaq OMX announced the acquisition of BGC Partners’ US Treasuries venue, eSpeed. In Europe, buy- and sell-side firms have signed up to develop a new platform led by Deutsche Bank. Many brokers are switching from trading as principal to providing execution-focused agency-broking services, acting as liquidity aggregators and providers of decision support.

Stu Taylor, former global head of matched principal trading – fixed income at UBS and CEO of trading technology firm Algomi, says fixed income trading is experiencing a “fundamental and permanent change”, but admits that both buy-side firms and their brokers will take time to adapt to the new reality.

“There will be resistance to any pressure on the buy-side to become price makers, because it is not the natural role of the asset manager. Although it works in small sizes, most previous attempts have failed,” he said.

Many of the building blocks are already in place for the buy-side to take a more active role in liquidity provision in the fixed income markets, according to Richard Phillipson, principal at investment consultants Investit, who acknowledges that the necessary change in mindset may be gradual for some.

“Few asset managers have appetite to change their business models but if brokers are not taking on inventory they may have little alternative,” he said. “Many portfolio managers’ valuation models implicitly offer a view on the price at which they would be prepared to sell a fixed income instrument. The covered call operations of buy-side equity desks already sell stock to other market participants at pre-set prices so perhaps the leap is not so great.”

With almost a third of poll respondents expecting wider spreads to push smaller firms out of the fixed income market, concerns about the future cost of entering and exiting positions in credit instruments is near the top of the agenda for many buy-side firms.

Speaking to last week, Robert Smith, chief investment officer for Texas-based Sage Advisory Services, warned of a two-tier system. “The new buy-side led bond platforms could lead to the creation of a ‘country club’ of bond trading where you need a certain size to be let in to the gentry of the marketplace,” he said.

Algomi’s Taylor suggested that a further bifurcation of the fixed income market could emerge as new venues and brokers competed to offer access to liquidity in the most popular instruments.

“There will be a split between heavily traded instruments with tighter spreads and buy-and-hold instruments, many of which will be fairly illiquid, but I still believe it will be possible to successfully issue bonds across a range of maturities,” he said.

Investment in bond funds has outstripped equities inflows in recent years, with issuance activity boosted by low interest rates and quantitative easing. But a number of fixed income investors have already been exploring the un-rated, less-liquid end of the spectrum. The long-term approach to fixed-income investment may continue to grow in the new environment.

“As spreads widen, institutional investors will need to be more confident of alpha generation for fear of losing too much when they exit a position. I’ve no doubt larger asset managers are modelling future scenarios in which liquidity is much reduced, but it’s harder to say whether they are already factoring these into their investment strategies,” said Investit’s Phillipson.

According to Taylor, however, the sell-side is working on new solutions to support clients’ search for liquidity.

“There is no rapid solution but innovation is starting to change how banks operate in this market,” he said. “We may find that existing fixed-income brokers simply become better at staying in touch with liquidity, but we might also see niche players entering the market, such as agency brokers that provide voice-broking services in the more liquid products.”