Blues for forgotten profits

A thriving, liquid secondary bond market was a available in the developed world before the financial crisis – it still exists, but the size of the market has shrunk as liquidity has drained from it.

Sometimes, the hardest thing to do is to spot something that isn’t there. Prior to the financial crisis, the existence of a thriving, liquid secondary bond market was a given in the developed world. Debt was issued, resold, and resold again. Investors bought, held and traded bonds with the studied and natural ease with which one, say, hands around a bowl of bar nuts.

Wind forward to late 2014. Secondary bond market liquidity still exists, much as those old VHS cassettes that were once displayed with pride on a prominent shelf still lurk somewhere in an attic or basement.

“Banks still act as active intermediaries,” said Jean-Marc Mercier, global head of debt syndicate at HSBC, continuing to operate as active intermediaries, particularly when it comes to supporting the issued debt of prized clients.

But the size of the market has shrunk as liquidity has drained from it, a situation that, said Fred Zorzi, co-head of debt capital markets at BNP Paribas, “isn’t going to change any time soon”. In a particularly damning report, issued in September, BlackRock painted the picture of a “broken market” desperate for reform.

Hammer blow

The hammer blow has come from tighter regulations. Designed originally to curtail leverage, a glut of new rules has instead undermined the willingness of lenders to make markets in corporate and in some instances also government debt.

Banks that once thought nothing of running sizeable risk positions have been forced to adjust to an uncertain and rather hostile new world.

Costs have soared on all sides, with lenders forced to hire new staff not to sell new bonds, or trade them with peers or investors, but to comply with stringent compliance rules.

Banks, said Tim Hall, global head of debt capital markets at Credit Agricole, have been given “little choice but to adjust their trading books accordingly”.

Armin Peter, head of European debt syndicate at UBS, said that by attempting to make the market a safer place, rule-happy regulators have merely succeeded in “making the asset class more uninteresting, so investors simply aren’t engaging to the extent that they were in the past”.

The loss of a once-vibrant secondary debt market has been the source of much grief on all sides of the financial spectrum.

Banks, already reeling from public and political opprobrium and an onslaught of regulations designed to rein in their more reckless tendencies, have been forced to retreat from a market that not so long ago was a true revenue-generation machine. The industry was dominated by size and risk appetite. Profits soared at lenders able and willing to hold hefty and risky positions on their books.

Yet a once highly profitable slice of the financial services space has, in the space of a few short years, become an ancillary business to many lenders.

“One of the traditional engine rooms of revenue generation at banks in the past was secondary trading,” said Sean Taor, head of debt capital markets, Europe at RBC Capital Markets. Yet falling volumes first trimmed, then slashed, earnings.

With profitability down and regulatory costs still rising, “some banks are being forced, even now, to make cuts in their headcount on the sales and trading side”, Taor notes. Financial institutions have excised entire trading teams from their books, with bankers winding up on the buyside or looking for work.

Brave new world

To be sure, banks learned to adapt to the brave new world, as they always have. Afraid of or unable to run a big secondary book, lenders have turned to the increasingly influential primary bond market for succor.

“If you’re not taking risk to earn money in [the] secondary, then you become more dependent on primary business to meet your overall profit targets,” said Credit Agricole’s Hall.

A dependency on primary profit has, in a short span of time, become “part of the ‘new normal’”, he adds. “Banks generally have to rely more on primary business, as do investors. Primary doesn’t chew up much capital, and it gets you close to issuer-clients and investors.”

It still comes as a surprise to some to realise how quickly, and completely, the rules of engagement have changed. Many banks struggle to gauge what issuance levels should be, and even to measure yield.

“Prior to the crash, you could be relatively precise on guidance, but you can’t do that any more, so all you can do is to offer the investors a much broader price range,” said Tim Skeet, managing director, financial institutions, DCM, at RBS.

“So the job of syndicate manager has become a bit of a guessing game, where establishing fair value has become a little bit hit-or-miss.”

Does this matter? That depends to whom you speak. A burgeoning primary bond industry has largely succeeded in masking the loss of a vibrant and liquid secondary market. Banks’ debt underwriting teams operate in a benign world where primary transactions are, in the main, comfortably oversubscribed, and both yields and new-issue concessions are low. It’s a “cocktail of positives” that tacitly encourages the issuance of fresh debt, said Credit Agricole’s Hall.

“Prior to the crash, you could be relatively precise on guidance, but you can’t do that any more, so all you can do is to offer the investors a much broader price range”

Some fret about the removal of a secondary market that once, said UBS’s Peter, “provided an invaluable buffer against” nasty surprises. In the old days, said RBS’s Skeet, the secondary debt market “could anticipate [price] movement, or absorb shocks”.

Investors and traders could evaluate the market’s mindset on an industry or a specific debt security through the tweaking of secondary spreads.

In recent years, this lack of a coherent, effervescent secondary market has been to a great extent camouflaged by a trio of factors: low interest rates, volatility, and the US Federal Reserve’s quantitative easing policy.

All three of those dynamics are now starting to evaporate. And when they do, BlackRock warned in its September report, “the extent to which today’s fixed-income markets is not ‘fit for purpose’ will be exposed”.

Bankers believe that the real test will come when primary bond market activity begins to slow, as seems inevitable, and even necessary, in the months and years ahead.

Day of reckoning

“A day of reckoning will come,” said Credit Agricole’s Hall, “when interest rates start increasing and/or spreads start widening. And that, he said would cause “opportunistic issuers to stay at home, and inflict costs on investors in terms of falling prices. With the bond business skewed more towards primary, there is a greater dependency on new issue volumes, and it is unlikely that secondary trading will be able to compensate when the volumes slow.”

The market’s woes have been a godsend for some. Leading universal lenders have in the main trimmed their secondary trading teams.

At the same time, investors accustomed to expecting a single financial partner to provide a full and unfettered range of debt services have been forced to cast their net further and wider. That has opened the door to solid second-tier lenders looking to put their own balance sheets to work for key clients.

“You see banks gaining market share in areas that previously were the purview of top lenders,” said Mariano Goldfischer, global head of credit trading and syndicate at Credit Agricole. “We have significantly increased our secondary volumes in the last few years due to the investment we made in trading, sales, and information technology.”

What, then, does the future hold? If – and, almost certainly, when – primary market issuance starts to wane, the revival of a forgotten secondary market is far from certain.

A sudden collapse in primary business may succeed in shoe-horning more liquidity into the secondary markets. A slew of non-Western lenders, including Chinese and Latin American banks, may ride to the industry’s rescue, as US interest rates rise and volatility returns.

But that may prove to be wishful thinking. Stringent regulations are likely to continue to suppress secondary bond market liquidity for the foreseeable future, bankers warn.

“I don’t think there will be more [secondary] liquidity in the future,” said one leading syndicate banker. “Nothing will replace it. This is the new world and it’s what investors need to start working with and getting accustomed to.”