You may have heard about problems in the bond market.
Barely a day goes by without someone adding to the chorus complaining about difficult trading conditions.
The problem, the argument goes, is that there is no liquidity. Investors can’t buy and sell bonds as easily as they would like.
The market for new bonds, in contrast, seems to be fit and firing. It has exploded in size as companies have rushed to take advantage of the low interest rate environment, selling bigger and bigger bonds.
But, according to research from Fideres, a firm staffed by former bankers that works with investors, regulators and lawyer, there may be problems there, too.
When a company wants to raise funds in the bond market, it asks a group of banks to help it place the bond. The banks talk to investors, run a roadshow, build a book of demand, and figure how to price and allocate the deal.
Conflicts of interest
Fideres argues that there are “numerous conflicts of interest in the placement process for corporate bonds,” and that as a result companies may have paid $18 billion more in interest than they needed to in the period from 2010 to 2015.
Here’s what you need to know:
- Fideres analysed almost 700 corporate bond deals from 2010 to 2015, and found a 0.50% increase in price terms on the day or immediately after the deals were priced. High-yield bonds had an average price increase of 1.5%, while AAA bonds had a price increase of 0.40%.
- “These very large increases are in excess of price movements that can be explained by fluctuations in interest rates or credit spreads.”
- US Treasury bonds, which are issued through an auction, show an average price increase of less than 0.15% over the same period.
- Bonds issued by the banks also see prices increase, jumping 0.30% after issuance, but this is still less than the 0.50% increase on corporate bonds.
In other words, once a bond is being traded, investors almost immediately recognise that a new issue is cheaper than it should be and the price rises. Bond prices move inversely to yields, meaning the companies probably could have issued the bonds at a lower interest rate than they actually did.
If fluctuations in interest rates don’t explain the changes, then what does? It could be banks that want to reward investor clients by selling them cheap bonds, knowing that they will jump in value, according to Fideres.
How do they get away with this? Because the companies selling bonds don’t know what the demand from debt investors is really like. That’s what the bankers are there for.
And banks, meanwhile, are serving two masters — the company selling the bonds, which doesn’t really know what the price of the bond should be, and investor clients who probably do.
Principal agent dilemma
Here is the key line from Alberto Thomas, a former banker at UBS and RBS who is now a partner at Fideres:
Firstly, the potential under-pricing of bonds is driven principally by an asymmetry of information. Dealers who manage the placement of the bonds know the level of demand from investors, but the corporations which issue the bonds and access the capital markets generally do not. Since the incentives of the two parties are not aligned, there exists a principal agent dilemma, which corporations cannot overcome since they lack the relevant information. The result is that lead managers may have an incentive to price the bond cheaply at the expense of their clients in order to achieve extra profits.
Secondly, upon learning of the under-pricing, the senior management of the firm which issues the bonds are then either unwilling or unable to challenge the pricing due to their firm’s dependency on the multitude of services that are provided by banks. The issue is then entrenched by a market concentration which prevents smaller financial firms from winning business from the larger players.
Now, there could be perfectly reasonable justification for some of this short-term outperformance versus auction deals and bank deals. Auctions take place on a regular basis, and there is a very well established curve for pricing. Banks are also frequent issuers.
It is more difficult, the argument goes, to get pricing right when a company issues fewer bonds, and when there are fewer comparables to work from.
Then there is that issue of liquidity. Investors, facing difficulty in buying and selling pre-existing bonds, have used the new issue market to buy in size. Investors are placing huge orders for bonds, and those that don’t get their fill in the allocation buy in the week or so after the deal is priced, when the bonds are most liquid. That bids up the price.
A similar phenomena takes place in the initial public offering market, by the way. Whenever newly listed shares rise by a huge amount on the first day of trading, IPO bankers are asked if they priced the deal too low (presumably in order to favour their hedge fund clients.) One common defence is that the “IPO discount” that led to the lower pricing is deliberate and encourages big funds to buy up huge chunks of stock.
Now, nobody seems interested in making any changes to the IPO process, despite the complaints. That is probably because companies only IPO once.
The bond market, in contrast, is huge and full of repeat issuers. More than $630 billion has been raised in the US bond market in the first quarter, for example.
That makes the Fideres research especially noteworthy.
Concerns around the new issue bond market have been bubbling away for some time. Some investors argue, for example, give preferential treatment to their best clients when allocating bonds. In feedback to a Bank of England-led review last year, a number of bond fund managers called for change.
UK fund manager Schroders said the transparency of the new issue process needed to be “reconsidered”. Aberdeen Asset Management said “the fairness and efficiency of the process has to be questioned.”
Watch this space.