Both the corporate and municipal bond markets continue to be shrouded in decades old business practices, provincial in nature and unfamiliar to many independent advisors and retail investors.
It is important to understand that unlike the equity markets, the credit markets are not consolidated exchanges where the bid and offer for a given security are the same for everyone, regardless of order size or customer profile. In other words, large institutional accounts receive preferential treatment with respect to pricing and new issue access.
Additionally, credit issues are much more finite and singular in nature than equities. The result is a fragmented marketplace where there are multiple bids and offers for a given bond at any time—sometimes none at all! These products and their prices are largely driven by supply and demand.
Institutional portfolios must adhere to the parameters of their stated investment policies, which define what securities are eligible for allocation. There are rigid requirements as to credit rating, maturities, country of issue, structure, and percentage of holdings, among others.
In addition, most institutional managers have their fund’s performance pegged to a particular product index such as the Barclays Intermediate U.S. Government/Credit index, thereby limiting their investment choices to index eligible issues.
A better understanding of bond market structure and the typical institutional investment process allows investors or their agents to identify inefficiencies, which can present value opportunities. It is essential to point out that most advisors and investors tend to rely on one broker-dealer/market-maker for security selection. Reliance on a single broker-dealer serves to limit the inventory selection and hence the ability to compare bids and offerings.
In the equity arena, many advisors rely on best execution principles where competitive pricing at differing broker-dealers for a purchase or sale is produced. In the fixed-income market, dealers commonly act as principals in the secondary market without a centralized trading mechanism, i.e. an ordered or consolidated exchange.
The Bond Sherpa – Three Principles to Guide the Investor
In order to achieve optimal performance when buying or selling bonds, three themes are critical to successful investing:
- ACCESS: A working relationship with an experienced dealer or advisor with access to the marketplace and the ability to negotiate the best and fairest prices.
- INFORMATION: Real time knowledge of current market levels and market conditions; insight into product idiosyncrasies such as mark-up practices, dealer strengths and familiarity with street positions; identification of relative value in and across product sectors; understanding of credit and interest rate risk.
- EXECUTION: Access and information lead to optimal execution—buying or selling a bond at the best price at the best time. As they say, “Don’t order fish on a Monday! “
Once again, unlike stocks, many different bonds can satisfy the parameters of a given inquiry. There are often many choices with regard to coupon, maturity, credit rating, industry, sector, etc… While each company’s business and stock are unique, multiple bond issues with common features can provide comparable investment solutions.
Be a Smart Shopper . . . Institutional Rules Need Not Apply
Timing is essential. Therefore, patience is required. Buying bonds by bidding when they are on sale will result in cheaper prices. Thousands of bond issues are in for the bid each day. Enlisting the advice of an experienced bond professional who has current market information and broad dealer access will increase the opportunities for good execution.
Consider buying odd maturities. Because most institutional buyers are tied to a specific maturity bucket (e.g. 10 year maximum), buying a bond one or two years longer may offer significant yield pickup. In the current environment of low interest rates (2.30 yield on the UST 10yr note), seemingly small increases in yield can be meaningful. For example, a 0.30% increase in yield can increase total return of a domestic bond by roughly 12%.
Dollar Price Effect. Many asset managers and investors have an aversion to high price, or premium bonds (above par), with higher coupons than current issues. However, premium bonds generally offer better yields, and offer higher returns than their lower coupon kin. There are three types of environments in which one purchases bond: rising rates, flat rates, and falling rates. As a general rule, one should buy premium bonds in a situation of flat or rising rates and discount bonds in a period of falling rates. Remember that cash flow from coupons—interest income—is a major component of total return calculations.
Supply, Demand, and Liquidity. As a result of Dodd-Frank regulations dictating more stringent capital requirements for the dealer community, we have an environment of reduced inventories, lower risk appetites, and less liquidity provided by bond dealers. Additionally, the impact of buying practices by Exchange Traded Funds and their associated Authorized Participants has skewed traditional credit relationships in the secondary market, which offers the investors higher return choices.
Invest Defensively. Remember, Not All Bonds Are Created Equal.
Good Fortune!
