Timothy Doyle, Fixed Income Portfolio Manager, Brandes Investment Partners
Structural and regulatory changes have motivated larger bond dealers to scale back their capital commitments – with significant implications for fixed income managers.
For some time, smaller bond managers were particularly challenged, often at the whim of larger players who carved up the transaction-dominant bond arena primarily among themselves.
Thankfully, there is good news for smaller fixed-income shops looking to effectively maintain exposure to this critical asset class. Interestingly enough, it has come in the form of what is usually a stigma-ridden catalyst: regulation.
The first helpful change has been evolving over the last decade. In 2005, FINRA launched the Trade Reporting and Compliance Engine (TRACE) system, which was akin to lowering the castle’s drawbridge for small bond pickers. Among other things, TRACE requires all over-the-counter transactions of eligible fixed-income securities, including corporate bonds, to be reported by all broker-dealers that are FINRA members (about 500 per day now).
TRACE immediately brought more transparency to a space that previously offered major advantages to larger players. As a result, information that used to be reserved for the biggest accounts—including the volume, price, agent, and transaction direction of trades—is now accessible in near-real time. Best of all, it helps prevent these institutions from manipulating prices. Considering these advances, it’s amazing how few bond investors actually know about TRACE and its consequences.
The second big change is the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which has also played a large role in leveling the playing field. With stricter capital requirements dissuading large institutions, like banks, from holding outsized bond inventories, they must work buy-side customer orders in the market instead of accumulating positions and selling from inventory.
With lower inventory levels, there is greater price volatility for corporate bonds ahead. This can create opportunities to identify and purchase potentially undervalued bonds at bargain prices.
So what do TRACE and Dodd-Frank mean for the future of fixed-income investing? Most importantly, that a great number of smaller managers have a better opportunity to compete with the larger players.
These firms have been given significant flexibility and leverage to exploit short-term selloffs that may arise in the newly leveled playing field, whether from overreaction to macroeconomic issues or events like ratings downgrades. Such selloffs generate market inefficiencies that can, in turn, open doors to buy bonds at steep discounts to their intrinsic value.
This is especially true of so-called “crossover” securities, fixed-income products caught between investment-grade and high-yield status. As investment-grade securities get downgraded, certain fund managers are compelled, if not mandated, to part from their holdings. At the same time, high-yield investors avoid these securities because of their lower yields, creating the potential for them to depreciate well below their intrinsic value.
These discrepancies form a sweet spot for smaller investors, which in turn could provide significant upside to a client’s portfolio without taking on higher duration or credit risk. Plus, with the potential for price increases in the balance, one could argue there is more insulation potential from rising interest rates.
Depending on the firm or strategy, managers will pinpoint different regions or sectors that illustrate this thesis. Again, such opportunities are easily missed if one pays too close attention to day-to-day volatility, often misconstrued as risk. A bottom-up, long-term, value approach to fixed-income can prevent managers from overreacting to short-term activity that typically would not have any real impact on a bond’s underlying fundamental value.
The upshot is therefore twofold. Firstly, changes from TRACE and Dodd-Frank have given discerning, smaller bond managers equal footing in the modern fixed-income environment. Secondly, these changes offer a timely reminder to keep an eye on the prize. For those who are patient, opportunities may await in value fixed income.
Timothy Doyle, CFA is a Fixed Income Portfolio Manager for the Brandes Fixed Income Group at Brandes Investment Partners, L.P. He is involved in strategy, portfolio management, and trading. He is also a member of the firm’s Fixed Income Investment Committee.