The credit crisis that began in 2007 has impacted fixed income transitions as the cost of trading has increased, liquidity has become harder to find and risks have multiplied.
Fixed income transitions are a highly specialized form of investment management, typically involving very short-term assignments with specific portfolio objectives. They fundamentally differ from equity transitions. The relative use of principal trading versus agency trading is different between the fixed income and equity markets, as is the nature of securities. For example, there is only one type of AT&T stock in the Russell 3000 index, but there are more than 40 different AT&T bond issues in the Barclays Capital U.S. Aggregate Bond Index. Some of these trade infrequently and may be interchangeable for each other in a target portfolio (while others may not). In addition, there is no centralised exchange for trading fixed income securities. These attributes have implications both for the construction of portfolios and the trading of securities.
Trading fixed income securities during a transition can be quite different from trading in the context of an ongoing investment management assignment. Typical fixed income managers may use just a handful of dealers for the majority of their trades, reflecting the concentration of liquidity based on manager/broker relationship and execution needs. Portfolio transitions, in contrast, demand intense focus on the harder-to-trade parts of a portfolio (which the ongoing investment manager would tend to buy and hold) and therefore greater reliance on a broad range of specialist dealers. The choice of how and with whom to trade a particular fixed income issue may differ, for example, by market sector, region, currency or size of trade.
Managing odd or small lot sizes (often less than 1 million par value) can also present challenges, particularly in fragmented and illiquid markets. Odd and small lots often require different types of brokers or execution approaches than those typically used to trade larger positions.
The credit crisis has impacted fixed income transitions
From mid-2007 onward, the fixed income markets were thrown into turmoil by the developing credit crisis. While government bonds remained relatively liquid (and much sought-after by investors seeking safety), all other types of bonds encountered tougher trading circumstances. Structured bonds were especially hard hit, not only those related to home equity, but also commercial mortgage-backed securities and other asset-backed securities. Bid-ask spreads expanded and trading volumes plummeted, as distressed sellers continued to apply selling pressure creating a downward spiral in credit conditions.
These market circumstances have affected portfolio transitions in a number of ways.
It is necessary to close attention to the pre-transition analysis of likely costs and the possible range of outcomes associated with a transition. As markets have become more expensive to trade, more volatile and riskier, the importance of that analysis is greater than ever.
Clients need to know what they are getting into. Given recent market volatility, a higher proportion of performance impact is attributable to differences between custodial valuations and actual price quotes in the markets. Clients must be informed of these pricing discrepancies and understand the impact prior to a trading event. If the likely cost of trading in these markets is prohibitively high, different strategies might be explored. Likewise, knowledge of where in the portfolio the main risks lie, and what these risks are, can affect the goals and expectations set for a transition.
As noted above, trading portfolios in transition has always been more reliant on a broad range of specialist dealers than trading other types of fixed income portfolios. As a result of the credit crisis, liquidity has become even more fragmented. This has occurred largely because of a decline in principal trading by large banks, resulting from their unwillingness (and inability) to commit capital to back this activity. The ability to work orders and leverage a broad array of relationships is even more important, as the pricing differential between working orders and principal bids can be substantial. Finding the other side of a buy or sell trade in the fixed income markets can be a question of knowing which electronic platform to use or who to call for the particular market, sector, or issuer under consideration.
Across a typical actively managed fixed income portfolio, the expected total cost of selling a given portfolio can today be some 25%-300% higher than it would have been two years ago and the expected cost of buying a given portfolio has also increased, albeit by less.
However, this increase in costs is not equally spread across a portfolio. Similarly, the increased risk that is associated with trading in thinner, more volatile markets has put a premium on risk management for fixed income portfolios in transition.
The design of trading strategies and choice of venues have been altered in response to the different environment, with an eye to duration management throughout the course of the execution process. But the greatest challenges lie in trading distressed securities. One response is to divide a portfolio into three liquidity categories: a liquid group, a tradeable group with limited liquidity, and a liquidity-impaired group.
The tradeable group with limited liquidity consists of those issues for which a contra-side can be found, but care needs to be exercised in accessing the available liquidity to ensure that the price obtained is the best in the market at the time of execution. Although this group is more difficult to trade than the liquid portfolio, a good fixed income portfolio manager should have the skills required to manage risks and trade it cost-effectively. Indeed, these skills are at the heart of fixed income transition management.
The distressed portfolio contains securities for which little or no market exists and which can be sold only at distressed prices, well below the perceived embedded economic value. It is this category, in today’s unusual circumstances, that have led to a new approach to transition management. The amount of a total portfolio represented by these securities varies and could be between 10-20% of a typical active core-plus portfolio.
These assets are put into a separate “workout” portfolio which is passed to a specialist sub-advisor. The sub-advisor will hold the securities for a prolonged period, working out of them over a period of perhaps 18 months or more (potentially years in some cases) when and if acceptable pricing begins to be available again. Often the sub-advisor makes the credit judgment based on in-depth credit and structural analysis to simply hold the position until maturity, maximizing the value of the asset for the client.
Workout portfolio assignments first appeared in mid-2008—and there are now roughly half a dozen firms offering this niche sub-advisor service.
With a workout portfolio approach, clients avoid becoming forced sellers in a distressed market and hope to realize the economic value of their investments through an orderly trading strategy or the final maturity of instruments. For a client facing the prospect of selling fixed income securities into today’s market at distressed prices, avoiding forced sales through workout portfolios can lead to significantly better outcomes—assuming perceived economic value becomes reality at some point in the future.
Travis Bagley is Head of Fixed Income Transitions at Russell Investments