A new report from the Tabb Group examines challenges in the fixed income markets. The report highlights the “laborious” nature of price discovery, which it calls “an increasingly expensive archeological excavation,” largely due to the incredible breadth of offerings. For example, the report notes that “[t]here are over 42,000 individual CUSIPs (IDs that identify stocks and bonds) in the U.S. investment grade and high-yield bond markets.”
In addition, investors had become used to a dealer-centric market in which the investor could quickly transfer risk to the dealer. Recently however, the report notes that dealers are increasingly using riskless principal trades, perhaps due to increasing regulatory and capital requirements. Thus, quotes from dealers have transitioned from a price where a security “would trade” to one where the security “may trade.” Thus, though there is an abundance of quoting information, market participants often remark: “[w]e see two-way markets all the time, and we can’t trade on either side.” These factors lead to a difficulty for asset managers (and boards) in assessing transaction costs and the ability to obtain best execution.
FINRA’s Trading and Compliance Reporting Engine (TRACE), introduced in 2002, was designed to address the lack of transparency in the fixed income markets by requiring reporting of execution time, trade price, side and volume. FINRA claims that the implementation has narrowed spreads, reduced transaction costs, improved valuation, and had no negative effect on liquidity. Europe currently has no such facility (though pending regulations would change this). However, the data provided by TRACE and the proposed European counterpart suffers from being backward-looking only.
In the absence of a regulatory solution, the report points to private efforts that are designed to improve information available in the fixed income markets. Given the aforementioned breadth of the fixed income markets, quotes are often disseminated in an ad-hoc manner by traders to individual groups. End-of-day pricing providers are working to parse the mountain of data produced by this environment to provide intra-day pricing, driven by requests from market participants. Additionally, several groups have developed or are working to develop standardized communication methods so that the data can be more easily processed. Pending regulation in Europe (MiFID II) will attempt to augment pre-trade price transparency and add a requirement for market makers to provide a continuous quote in a machine readable format.
Assessing best execution in fixed income markets is particularly difficult because of the lack of pre-trade transparency. As the report points out, finding reliable information to use when making trading decisions has gotten even more complex in the wake of the financial crisis. The overview of the current markets as well as the pending developments – both from a regulatory perspective in Europe as well as the private efforts to serve the needs of market participants – may help directors when discussing how the adviser makes trading decisions in the fixed income markets. Further, the report serves as a reminder that the markets are rapidly evolving and it is important to stay abreast of the changes. More information about fund portfolio trading practices is available for Forum members here (login required).