A great piece on the US bond market by Tracy Alloway and Mike Mackenzie has plenty to consider on Monday. Some will be familiar to those in the market — there have been a ton of inflows and liquidity has dried up — but ponder also some of the behaviour described when it comes to allocating bond sales.
Because rules for bond allocations are not set in stone, most bankers and fund managers do not believe they are doing anything illegal, though some expressed misgivings about a practice they describe as more art than science.
A long boom, insatiable demand for what banks are selling, possible different treatment of the large and the small buyer. Any of it starting to sound familiar? Investigators like to stroll along the sand once the tide has gone out. Recall the look at initial public offering practices during the dot com era by Elliot Spitzer, for instance. But remember too the tendency in finance for an ethical line to be edged past in the search for advantage. At the time practices can seem merely aggressive, or cynical, but when attention turns to them much later it becomes obvious the line is now distant. Think the treatment of soft commissions, client entertaining, analysts saying one thing in public and another in private, libor or foreign exchange traders traders chatting, or naked shorting, for instance.
Which isn’t to say there is widespread bad behaviour in the bond market, far from it. Rather it is to point out how the cycles in these things go. As retail investors have piled into bond funds over the last decade, any market correction resulting in losses may prompt more attention on what is going on.
Do read the whole thing, but here’s another extract:
Speaking on condition of anonymity, several senior bankers said the largest bond managers exert disproportionate influence on the size and price of new debt sales. The behind-closed-doors process by which new corporate bonds are priced and then doled out to investors means that opportunities for questionable — though not necessarily illegal — behaviour exist, these bankers say.
Big bond funds that trade with a bank in the secondary market are more likely to receive a larger allocation of new debt deals underwritten by the firm — a classic case of quid pro quo behaviour, according to bankers. The most powerful bond funds are also able to alter the price of a debt deal, often pushing for new bonds to be sold at a wider, or more profitable, spread for investors, they add.
One former credit trader at a bank recalled keeping track of which clients do the most “favours” for the firm to ensure good allocations in desirable new deals. A former senior banker at a well-known US bank said more than two-thirds of the firm’s credit trading revenues were tied to its underwriting business. Others described their competitors creating fake orders to get more bonds that could then be given to their biggest clients.
A former syndicate banker at a large US bank described being goaded by a sales manager to alter the pricing of a bond offering to satisfy a powerful buyside client: “Then I have to basically lie to the issuer and tell them they can’t get a better deal. One time, I even had to modify the limits in an order book that they requested to make it look like a tighter deal wasn’t in the cards.”
Bankers would “rather allocate to the big guys at a wider level than smaller guys at a tighter level”, says David Schawel, portfolio manager at Square 1 Bank.
As Tracy and Mike point out, the SEC devotes half of one person’s time to corporate bonds, versus more than 100 focused on the stock market. For anyone feeling uncomfortable in the water, it might be a good idea to get out early.