Efforts to make corporate bonds more appealing to retail investors have reached a crossroads, and their ultimate success or failure now depends in large part on whether financial advisors acquire an appetite for them.
The advisors, of course, must take their cues from their clients, but first they need to bone up on the bite-sized bond investments known as retail notes to better handle the inevitable questions from clients when they come.
“Any registered rep that is not familiar with selling individual bonds is going to have to learn,” says Tom Ricketts, chief executive of Incapital, which laid the foundation of the retail notes sector in the mid-1990s. “It's got to be in their bag of wares because pretty soon the customer is going to require it.”
The process of deciding whether to add retail notes to a portfolio starts with evaluating the client. For “mom-and-pop” investors — those who have stayed away from bonds in the past because of anxiety about the confusing pricing in the bond markets — retail notes programs are tailor-made. On the other hand, wealthy investors looking for capital gains, the programs may be a bit too constrained.
John Claghorn, a senior vice president of wealth management at RBC Dain Rauscher, says he uses retail notes programs for a specific reason — to find short-maturity bonds for quick in-and-out investments. “It's very easy and convenient to buy short-term paper for clients with these programs,” he says.
Pros and Bonds
The pros of retail notes are obvious — the programs bring buying bonds down to size, simplifying the process of purchasing corporate debt and reducing timing-related pressures. The programs offer investors a list of bonds to choose from every week, always priced at par and issued by a list of top-rated companies, including General Motors Acceptance Corp. (the financing arm of General Motors), IBM, Caterpillar Financial Services, Dow Chemical and Daimler Chrysler.
The alternative, buying bonds directly in the secondary market, can be quite an ordeal for retail investors of modest means. There are frequent price fluctuations and markups to contend with. Sometimes investors have to pay as much as half a percentage point higher than the original issuance price. Investing in bond funds can be even costlier, with up to 25 percent of returns gobbled up by management fees.
Still, retail notes are not made to fit every advisor's strategy. For starters, the list of entities issuing bonds is limited — only about 35 issuers participate in the programs, and not all of them regularly. Further, the programs are designed for conservative investors — those who buy bonds and hold them to maturity. If an investor needs to sell them, he can; the banks involved try to maintain a liquid secondary market for the bonds. However, don't expect to make any quick money doing so, as participating banks try to hold bonds at roughly equivalent prices.
The retail notes sector is dominated by three players — LaSalle Broker Dealer Services (a division of ABN AMRO), Incapital and Merrill Lynch — with a handful of other companies offering primarily self-issuance programs. LaSalle, Merrill and Incapital each act as supervisors for their respective retail note programs, signing up corporate bond issuers and arranging the sales of the bonds on their Web sites.
Though bond investing often has lived in the shadow of the equity market for reps and clients, the greater protection and reduced volatility of bonds often prove more attractive to many aging investors. “The demographics of the marketplace are remarkably in favor of our program — the aging of the population, the growing desire to protect wealth,” says Patrick Kelly, managing director at LaSalle.
Kelly regularly attends broker/dealer conferences to deliver the bond gospel: In the long run, bonds are often a superior form of investment for smaller investors. “Many people don't buy bonds because they're confusing — they don't know what accrued interest is, what the various provisions are,” Kelly says. “To solve the puzzle with respect to retail investors, you need to make bond investing easier.”
There are signs that investors are warming to this message; there is a growing preference for direct ownership of bonds, rather than entering the bond market indirectly via funds. Advisors sense this shift.
Incapital recently surveyed 824 financial advisors and found most now prefer to first offer clients individual bonds. When asked which products they most often recommend for fixed-income allocations, 36 percent of respondents said individual bonds, and 25 percent said they recommend an even mix of bonds and bond funds. Only 27 percent most often recommend bond funds.
From Slow Burn to Boom
The history of retail notes dates back to 1996 when Chicago Corp. pitched one of its clients, GMAC, the idea of doing a supplement to its existing corporate bond programs. The premise was simple: In addition to standard corporate bond financings, which are aimed at the institutional investor community, GMAC would also set up a side retail-oriented business, selling bonds in $1,000 increments at par, regardless of market conditions. The concept has basically remained the same ever since. On a recent week, for example, a retail investor could click on GMAC's weekly listing on LaSalle's Web site and choose from seven offerings, ranging from a 4 percent bond maturing in 18 months to a 7.25 percent bond maturing in 20 years — all at par.
The retail notes program remained relatively small through the end of the 1990s, in part because bonds were out of fashion. In 1999, Ricketts and some associates left ABN AMRO to form Incapital and leveraged their experience with the GMAC program to create a wider market space for retail notes. Competition between Incapital and ABN AMRO (which had handed the program over to its LaSalle division) spurred market growth, with each soon nabbing top-rank issuers.
Interest in retail notes grew further between 2000-2001, when the stock market tanked and traditional bond markets were volatile. Suddenly, mom-and-pop investors seemed like a good source of financing for issuers.
“Issuers who had gotten used to an accommodating institutional fixed-income market were now faced with choppy markets,” Ricketts says. With retail notes, “issuers get a new source of funding. That's one less time they have to go to Europe or do an institutional deal. It takes a bit of pressure off [bond prices in] the secondary market and that is a value unto itself.”
The current market share breakdown is as follows: LaSalle has 46 percent, and Merrill Lynch and Incapital have 20 percent each. The remainder is self-issuance programs from the likes of Bear Stearns and Lehman Brothers. LaSalle's Direct Access Notes are sold by about 725 b/ds, and participating issuers include Caterpillar, the Tennessee Valley Authority, John Hancock and SLM. Incapital's InterNotes are distributed by about 325 b/ds, and participating issuers include Boeing Capital, General Electric Capital and Bank of America, which owns a stake in Incapital and was the first issuer in the InterNotes program. Merrill offers notes from the likes of Ford Credit.
Challenges
Many b/ds are sold on the virtues of the retail notes programs. “We think it's appropriate for the retail client, given that all the new issues are equal,” says George von Zedlitz, senior vice president and head of fixed-income sales and services for Charles Schwab & Co., which offers clients access to both Incapital and LaSalle's programs. “Someone buying one bond will get the same price as a person buying a hundred.”
With retail notes, offered at par, “there is no accrued interest, so you buy a bond for $1,000 and you get $1,000 at maturity. In between investors get coupon payments.”
However, there are signs that the retail notes market has reached a temporary ceiling, as new-issue volumes have remained relatively flat in the past two years. Part of this is simply due to investor wariness about buying bonds due to rising interest rates.
Some innovations are spurring new interest — for instance, “laddering,” in which investors pick a variety of bond maturities and create a portfolio that spans the maturity spectrum. But bankers believe that retail notes will continue to grow, simply because the sector's core simplicity cannot be topped. “Instead of walking into a bank, you're just walking into Freddie Mac or GMAC,” Kelly says.
The doors should remain open for quite a while.