Corporate Bond Best Execution. More Art Than Science

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1 Corporate Bond Best Execution More Art Than Science

2 CONTENTS Introduction 3 The Art of Deciding Whom to Call 4 Finessing the Screen 4 Getting the Trade Done 5 Why Best Ex Matters 5 Internal Policies 6 Quantifying the Art 6 Conclusion 7 GRAPHICS Respondents 2 Electronic Trading Activity 3 Value Provided by Dealers 4 Methods Used to Reward Dealers for Research 4 Most Important Factors When Requesting an Electronic Quote 5 What Dealers Can Do to Gain More Business 6 RESEARCH GOALS AND METHODOLOGY 2% This report provides detailed information on bestexecution practices utilized by fixed-income investors located in the U.S. Research is based on in-person and telephone interviews with 114 high-yield credit and 119 investment-grade credit investors throughout % 9% 5% 57% Funds/advisors Hedge funds Insurance companies Other Banks Cover Photo istockphoto.com/romaoslo 2015 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. GREENWICH REPORT 2

3 Introduction Trading corporate bonds is an art. While use of quantitative modeling and real-time evaluated bond pricing have grown dramatically over the past decade, finding the buyer or seller for the other side of a bond trade remains principally in the realm of intuition and experience. This is in large part why automated trading in corporate bonds has lagged behind other more electronic markets. Computer algorithms follow precise instructions to accomplish a task. If the decisions and actions a trader takes to execute an order can be documented then trading can be automated. Computer-managed limit orders gave way to volume-weighted average price (VWAP) algorithms, which ultimately led to the high level of automation seen in many major markets today. Corporate bonds have been largely absent from this automation trend, however, as the decision tree used by traders to execute a bond trade has proven difficult to automate. Electronic Trading Activity High-Yield Credit Bonds Do not trade online 57% Trade online 43% Note: Based on responses from 114 high-yield credit investors in the U.S. in Source: Greenwich Associates 2014 North American Fixed-Income Study 4% 96% Volume traded electronically Volume traded traditionally Total electronic volume: $18 billion Regulators aren't good with grey areas, and this is grey. ~Large insurance company Despite this, electronic trading in corporate bonds has grown over the past few years 16% of liquid investment-grade bonds are traded on the screen. But even those trades are mostly point-and-click, with a trader still in control of when the order is entered, who sees it and at what price it is ultimately traded. For less liquid corners of the corporate bond market, including most high-yield issues, automation is even more tepid with only 4% of volume traded electronically and the trader firmly in control of order execution. The difficulties inherent in automating the art of bond trading also explain why defining best execution continues to be such a challenge for institutional investors. You know it when you see it doesn t cut it for auditors, regulators and large asset-owner clients. With regulatory scrutiny of bond-market activity high and investors increasingly in tune with market structure and liquidity issues, taking the trader s word that they did the right thing to achieve best execution is no longer sufficient. Kevin McPartland is the Head of Research for Market Structure and Technology at Greenwich Associates. He helps the Firm s clients navigate market structure changes driven by regulation, technology and behavior shifts. GREENWICH REPORT 3

4 The Art of Deciding Whom to Call Before discussing how the buy side currently measures best execution for corporate bond trades, and how best to improve those processes, it is important to first understand how traders find liquidity and ultimately decide with whom to trade. If a strong relationship will meet the best price, then you'll trade with them instead. ~Medium asset manager Methods Used to Reward Dealers for Research High-Yield Credit Investors and Investment-Grade Credit Investors United States Give first call to the dealer that provided the research Include dealer more often in a request for a quote Research is a tiebreaker when all other factors equal Execute trades on a non-comp basis with the dealer that provided the research 3% 12% 18% 0% 20% 40% 60% 59% Note: Based on responses from 114 high-yield credit investors and 119 investment-grade credit investors in the U.S. in Source: Greenwich Associates 2014 North American Fixed-Income Study As illustrated below, investors are first and foremost concerned about the secondary-market trading expertise of the potential counterparty. Selecting the best here can be very different depending on the sector, currency, company, or size of the bond issue. While relationships play a part, the decision is also about who was the original lead underwriter, has traded or has expressed interest in trading the bond or a similar bond recently, and who knows the trading dynamics of that issue. Most buy-side traders have this information not on a spreadsheet but in their heads. With that thought process complete, access to new issues, sales coverage, research, and other services provided are also factored in. For example, nearly 50% of buy-side high-yield bond traders will give first call to a dealer that provides them with valuable research. It is interesting to note, however, that very few will show an order to a top research-providing dealer on a non-competitive basis. This is due in large part to bestexecution requirements (more on that shortly). Last but not least, compliance restrictions must be observed. In corporate bond trading very few limitations are put on a trader working to execute a client order, most of which are enforced by the order management system (OMS) on the desk. Some clients request that certain counterparties be used for certain trades (or not be used for that matter), but no other compliance restrictions were cited by our study participants. Finally, although the above thought process is often carried out in a matter of seconds, the trader has a mental short list of the dealers to call with the highest probability of success. For more liquid names where information leakage is a lesser concern, the list tends to be longer (electronic RFQs can go out to dozens of dealers), while for less liquid names where a single trade can move the market the list is short, sometimes only one. As one study participant explained information leakage: The soufflé only rises once. Finessing the Screen When requesting quotes electronically, there are some additional elements that buy-side traders also take into account. Three out of four traders in our most recent fixed-income study stated that the dealers who stood behind the prices they quoted on the screen were the Value Provided by Dealers High-Yield Credit Investors and Investment-Grade Credit Investors United States Average value point allocation (total points = 100) Secondary trading New issues Day-to-day sales coverage Ideas from desk analysts Published research Senior relationship management efforts Back office operations Note: Based on investors allocation of 100 value points across service categories. Based on responses from 114 high-yield credit investors and 119 investmentgrade credit investors in the U.S. in Source: Greenwich Associates 2014 North American Fixed-Income Study. GREENWICH REPORT 4

5 Most Important Factors When Requesting an Electronic Quote High-Yield Credit Investors and Investment-Grade Credit Investors United States Best at executing at price shown 73% Consistently fast quotes 46% Consistency of hit ratio by trade count* 33% Consistency of hit ratio on large trades Consistency of hit ratio on small trades 26% 26% Salesperson support Dealer performance in another fixed-income asset class 10% 14% To reward for research or trade ideas 5% 0% 20% 40% 60% 80% Note: *Number of hits relative to number of trades shown. Based on responses from 114 high-yield credit investors and 119 investment-grade credit investors in the U.S. in Source: Greenwich Associates 2014 North American Fixed-Income Study ones that would get preference. While some were more concerned with consistency on large trades and some on small, the expectation that electronic quotes are firm, even if dealers technically do have last look, is increasingly prevalent. Trading corporate bonds electronically requires just as much art as trading via the phone. So while tracking best execution is certainly easier as electronic trading brings with it an audit trail, determining who should see a given RFQ still requires experience and knowledge of the Street. Getting the Trade Done With potential counterparties chosen and RFQs sent, it s time to (hopefully) execute the trade. Common practice is to choose the best price of the three or more quotes received. When that is the case, the majority of buy-side trading desks assume best execution standards were met. This long-held approach is flawed, however. Assuming the best price of three is the best available assumes that the other ten or more dealers that were not included in the RFQ could not have beaten those prices. Things get even more complicated when either the best price is not chosen or only one price response was received and, therefore, was the only option for execution. The former situation can occur when the best price received is for only a portion of the order. For example, if the order was for $15m and best price was only for $10m, the trader might chose to execute at a higher price to ensure the entire order is filled. If the best price is too small a size, then we'll go with the guy that will do the whole trade. ~Large asset manager The latter situation, where only one executable price was available, leaves the trader and his knowledge of the market as the only way to confirm best execution requirements were met. The most common method cited for documenting best execution in this situation: the comment field on the trade ticket. Why Best Execution Matters The buy-side trader s job is to carry out trade execution quickly and efficiently, day after day. If the hiring process and the people involved in it were perfect across the industry, we would not need best-execution policies. Sadly, that is not always the case, and regulators require more assurance that the interest of the endinvestor is being protected. Thankfully, key regulators overseeing the bond market in the U.S. have some grasp of the art of achieving best execution and do provide investment firms with some latitude to do so. While our study participants all had established internal policies, no one made note of regulatory requirements beyond the need to have a policy in place. GREENWICH REPORT 5

6 The SEC in setting forth requirements for fiduciaries of pension funds explained the approach taken by market participants well: The Commission wishes to remind money managers that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account. The goal is best execution, which is not always equivalent to best price. The trick is proving it with data and not simply trader intuition. Internal Policies Investment managers of all flavors take a similarly flexible approach to corporate-bond best execution. Policies make no distinction between product types (high yield as compared to investment grade, for example) or between customer types (i.e., mutual fund vs. pension fund). Many study participants did explain slightly different approaches taken for liquid and illiquid securities, however, with a much more liberal policy in place for the latter. What Dealers Can Do to Gain More Business Trade ideas Transparency Liquidity New issue Relationship Large orders Buy-side liquidity Workflow High yield Investment grade 2% 0% 1% 0% 4% 4% 8% 13% 24% 20% 25% 20% 25% 32% 36% 43% 0% 20% 40% 60% Note: Based on responses from 136 asset managers and hedge funds in the U.S. in Source: Greenwich Associates 2014 North American Fixed-Income Study Our quants look at data from TRACE and Bloomberg to find outliers. They also use that data to determine which bonds are liquid and illiquid. ~Large asset manager When trading illiquid securities, the approach is intuitive. There are often fewer counterparties willing or able to quote a price in the given issue, and information leakage is a much greater concern. When asked how dealers can gain more of their business, traders of high-yield debt, which is generally less liquid than investment-grade debt, were first looking for trade ideas. More importantly, they were more interested in the market transparency the dealer could provide than liquidity further explaining the need for a different best-execution approach. About half of study participants conduct quarterly best-execution reviews that examine a random sample of trades for both best execution compliance and for those trades that raise red flags. Less than 25% conduct these reviews monthly and under 20% review twice a year. These meetings are critical for audit purposes. Despite the lack of defined regulatory requirements for best execution, investors strive to document as much as possible, in an effort to provide as much transparency as is needed for regulators when and if details are requested. Clients, of course, are a major driver of clear bestexecution policies. While clients rarely ask for details of individual trades, nearly every study participant noted that most RFQ responses require discussion of bestexecution policies. Clients are more aware of market structure and liquidity concerns today than ever before, and as such want to understand what their potential investment manager is doing to minimize those risks. Quantifying the Art Investors have access to a number of data sources when examining executed prices post-trade. All buy-side traders utilize FINRA s TRACE data in some capacity, with data from Bloomberg, Markit and Interactive Data also common inputs to the best-execution process. While these data sources are good and only getting better, in a market where some securities trade once a week or once a month, comparing a trade price from two days ago with the price executed today creates an apples to oranges comparison at best. GREENWICH REPORT 6

7 Real-time evaluated pricing for corporate bonds has also seen a notable improvement in quality and distribution over the past few years. These services provide an additional level of transparency into the market beyond the last-traded prices, but cannot always account for client and situation-specific nuances, as noted above. Clientcounterparty restrictions, trade size and dealer relationships might all yield a price that differs from the evaluated price, still leaving internal compliance teams looking for more. The needed solution is one that ingests all of the aforementioned data, both actual and evaluated, and layers on top of it the additional factors until now only resident in the head of the trader. This should include but is not limited to previous trading history with dealer counterparties, underwriters for given bond issues, sell-side research focus, axes, and non-executed quotes. This is data that can be used not just by compliance post-trade, but also by the traders to help them make their counterparty and execution decisions more efficiently than is possible today. Methodology This report provides detailed information on best-execution practices utilized by fixed-income investors located in the U.S. Research is based on in-person and telephone interviews with 114 high-yield credit and 119 investment-grade credit investors throughout The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. Conclusion Defining what is best in nearly every scenario is a matter of opinion. What I believe to be the best slice of pizza in New York is likely different than yours. Best execution for a corporate bond trade today is equally as subjective, but thankfully an increasingly large store of data is now available to put additional weight behind what in the past was only one person s opinion. If you're in the market your job is to know what's best where to execute and which counterparties to use. ~Large asset manager Requesting three quotes does not ensure best execution, and that assumption is one based in an old market structure that no longer applies. Selecting the best of three does not account for what might have been a better price if selecting from five or ten. Conversely, requesting a price from only one dealer the right dealer could also yield a better price, as the trade was not competitive. With clients and regulators scrutinizing every aspect of the investment process today, investors must gather and store every piece of data possible to document that best execution was sought beyond a reasonable doubt. Now it s up to the technologists to turn the art of trading into a science. n GREENWICH REPORT 7

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