April 19, 2013
My insight will focus on Panel 4 - Potential Improvements to the Market Structure for Corporate Bonds and Asset-Backed Securities.
General
The major weakness for the fixed income money manager is the present environment of being under researched. The scarcity of research is due mainly to the effect of The Global Settlement (2003) which separated research from the investment banking department and through the disclosure required in the new Form ADV which has curtailed their equity client's commissions being directed to their fixed income client's research. While the Mutual Fund Task Force (2004) and the SEC '06 Release have directed fiduciaries to third party research, a large percentage of fixed income money managers are not aware that they can use their client's brokerage commissions or markups/markdowns to acquire pertinent third party fixed income research. It is especially harmful for money manager's clients who are purchasing less than investment grade bonds. The present situation of artificially low interest rates, mainly directed by the Federal Reserve, is creating an environment where the money managers need to go down the ratings curve to acquire adequate yield for their customers. We have issued more high yield securities in the last two years than we did in the prior twenty years These junk bonds are being issued by the investment banker without access to research. The money manager is buying these risky securities without access to pertinent third party research and creating a potentially hazardous situation for their clients and opening themselves up to potential lawsuits. Research is the foundation of the money management industry. Therefore, there needs to be clarity from the SEC that money managers can acquire pertinent third party fixed income research, as stated in the '06 Release under footnote 27, with agency transactions and fees on certain riskless principal trades where there is a trade reporting system to verify and the markup/markdown is on the confirmation.
Pre-Trade Transparency
Electronic trading in the fixed income market pertaining to corporates and asset backed securities may have its limitations. Unlike the stock market, where there is only one price for a security, the same company may have hundreds of bond issues that are outstanding. Each one of these issues has different characteristics, such as length of maturity, call dates, size of issue etc. The secondary bond market is truly a negotiated market. Depending on the underlying credit of both the corporation and the asset backed security, the ability of a dealer to put a two sided market on all securities is unrealistic. As we noticed in the home equity market in June 08 when the delinquency rate in the ABX Index soared to an unprecedented high, the dealer community was almost non-existent. The only way that money managers could execute transactions, was strictly on an order basis (putting a buyer and seller together) on a riskless principal transaction. Electronic trading does have a purpose in more liquid bonds, but is not a panacea for the money manager.
Post-Trade Transparency
Currently, Finras TRACE system does require reporting on riskless principal transactions. In TRACE reporting, you have the trade that took place between two brokers (inter-dealer trade) and you also have the reporting of the trade and price to the customers. Presently, 95% of all corporate bonds are TRACE reportable. One measure that may increase transparency would be a change to Rule 10b-10 that would require the markup/markdown on the fixed income trade to be on the confirmation. While the fee is available if one goes into TRACE, having the markup on the confirmation would provide further disclosure.
Better Investor Information
The main reason why the SEC created the net capital rule for positioning broker dealers was to enhance the liquidity for the money managers and individuals who purchased bonds from the dealer. This was especially important in the marketing of new issue fixed income securities. The purpose was not to give the dealer a leverage advantage so they could use that net capital rule to run a prop desk for the dealers own benefit.
If a dealer is transacting a bond in or out of position, the total gain or loss does not need to be disclosed due to the inherent risk that the dealer assumes by positioning the security. As mentioned in the roundtable, the average length of time that a bond is in position is approximately three weeks. The gain or loss on the position is due to many factors. Therefore, stating the gain or loss to the customer is not pertinent.
Best Execution
Best execution, as described by the SEC, is a combination of research, execution, clearing, and other brokerage services. One concern that the SEC should be aware of is the lack of best execution practices for the newer RIAs that have high net worth customers. A large percentage of these RIAs were formerly registered representatives who were able to take their clients assets from the broker dealer and place their securities with a custodian who also acts as their prime broker. However, they do all of their fixed income transactions with that prime broker rather than meeting their fiduciary responsibilities by checking away. A lot of these newer RIAs are not aware of their requirement as a fiduciary to seek alternative offerings from their prime broker. In many cases, the bonds offered from the prime broker are priced substantially higher than similar bonds in the bond market (i.e. the brokers market).
Primary Offerings
The new issue market is presently held in a cartel type environment where access to capital through new issue fixed price offerings can only be done with a handful of investment bankers. As stated in the roundtable, a company that would need capital to further enhance their entity presently may be too small for these large investment banks. Sometimes a billion dollars would be the minimum that an investment banker would issue. In my opinion, it would be in the best interest of the public if this cartel type environment was broken up and access to the issuance of registered securities was available to a large number of new, budding investment banks. Any market in the hands of just a few is generally not in the best interest of the public.
Summary
I personally want to thank you for hosting Tuesdays roundtable. We are all striving to improve our industry. As stated in your September 22, 1998 Inspection Report, Research is the foundation of the money management industry. For the public to entrust their savings, especially their pensions, to a fiduciary that does not have or seek pertinent research before they invest is a breach of their fiduciary responsibilities. We should also strive to provide as much transparency and disclosure, in our execution process, as possible.
Yours Truly,
Tom Shugrue
President, CCM