Fixed income transition market 'expanding, not contracting'

Fixed income transition market 'expanding, not contracting'

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While transition management has become a very well-established practice for the restructuring of equity portfolios it has not typically been associated with fixed income, despite the heavy use of the asset class by institutional investors. While there may be some reticence to use transition managers for over the counter (OTC) asset classes, after a couple of well-publicised scandals in recent years, the lack of transparency of these markets is now one of the key drivers pushing them into the arms of transition managers.

While institutional clients have always been big investors in fixed income, and are not necessarily investing more, they are increasingly comfortable bringing in transition managers to restructure portfolios. “Investors used to give investment managers bond portfolios to restructure as these are less liquid markets,” says Artour Samsonov, head of transition management, EMEA, Citi. “However, as transparency becomes more important, with clients needing to present clear reporting to boards of trustees, the transition management framework is being applied to fixed income restructures more frequently.”

Growth has been rapid in recent years, says Ben Jenkins, senior vice president, global head, Northern Trust. Fixed income now accounts for 15% to 20% of volumes on an annual basis, up 30% to 40% in the last five years. “It was once the case that few people knew how to do fixed income transitions,” he says. “We have since seen growth and in very short order fixed income transitions became more global with 45% of fixed income business now in non-US bonds, despite the US remaining very strong for bonds.”

Asset allocation

The importance of European and Asia Pacific fixed income instruments is indicative of the exposures clients are running and why their needs have expanded. While a legacy manager may know how to liquidate the portfolio, they are not best placed to do so. “Asset managers never build portfolios with the mind-set that one day they will get fired,” says Jenkins. “Sometimes these portfolios can be tricky to trade, if they contain small names, are well diversified and cover emerging markets.”

Clients are experiencing sleepless nights due to three types of risk – liquidity, funding and managing assets in-between portfolios – and are increasingly turning to transition managers to control them. In the past, says Jenkins, the restructuring of a portfolio could end up with shortfall that nobody seemed to know how or why occurred, but transition managers can help clients understand and avoid such problems. Aside from pre and post-trade reporting services, transition managers can more accurately predict the total cost of the transition, adds Jenkins, which in his case is within half a basis point of cost estimates.

The search for yield has become so acute that it is chasing out time-honoured practices that can no longer justify their existence. Simply selling out from a legacy manager and transitioning to a target manager is possible, but it is inefficient and losses can be made. Forcing assets onto a target manager is equally ill-advised, says Cyril Vidal, executive director and co-head of transition management at Goldman Sachs, as it is likely that the client will have to give up further returns by offering that manager a performance holiday.

Transition managers can deliver gains to the client by simply being examining things from their perspective and looking for efficiencies within their portfolio. “The first task of the asset manager in a fixed income transition is to discuss with the target manager a way to recycle existing bonds into the target portfolio,” says Vidal. “This is usually an iterative process and the transition manager needs to ensure this process is not detrimental to performance, by adding opportunity cost, and does not affect the strategy of the target manager, such as by changing the duration of the portfolio.”

Advanced program trading systems, equivalent to the ones used for equities, cannot be applied to fixed income, says Vidal. It remains a highly manual process and, as a result, technology will not provide a solution to the inherent complexity of this asset class any time soon. “The fact that you can’t improvise is a high barrier to entry,” says Vidal, who adds that personnel is the most critical contributor to successful transitions within fixed income.

Executing in equities across multiple connected venues gives you a wide range of liquidity sources – and an open architecture provides a wide range of counterparties – but fixed income requires highly specialised knowledge and skills that aren’t available at the flick of a button.

And it’s not something to take on trust, either, as some companies might look well-prepared, but may not have the necessary strength and depth. It needs to be checked thoroughly. “We deal with illiquid assets either through a wide range of counterparties or by knowing natural holders of bonds within our franchise,” says Vidal. “While we will make better use of technology, a big part of our business is knowing where the interest lies.”

Experience counts

Few would question that the ability to effectively transition fixed income, above all asset classes, is based upon the manager’s key personnel. “This is exactly the kind of business where experience counts,” says Jenkins, “where people matter and experience will lead to better results.”

As the highly diversified portfolios of rapidly maturing pension schemes seek to restructure increasing numbers of them are seeking better results, says Jenkins. For example, Northern Trust recently undertook a restructure of a $60m portfolio with 300 names that had fallen out of favour and simply didn’t work anymore. It consisted of emerging markets and high yield bonds and, in developed markets, mortgage-backed securities and convertible bonds. The trouble was that the holdings were all well below institutional size, so small they couldn’t be traded easily. This required a custom solution and highlighted the importance of preparation.

“It is a good idea to receive a careful explanation of the portfolio before a manager is terminated,” says Jenkins. “This is often not well considered when it comes to emerging market and high yield components. Yet these assets have different risk profiles and may need some time to be sold out or crossed. You will have to rely on the team at the transition manager and need to know they have staff with the necessary expertise.”

Though due diligence is essential in any transition – as it is all about measuring, reducing and controlling risk – perhaps too much is made of liquidity, even in fixed income markets. It is not because emerging markets and high yield are necessarily any more illiquid than others, but that they are much more susceptible to market shocks, says Citi’s Samsonov.

“The investment grade corporate and sovereign bonds are generally liquid instruments. But governments buying up anything they can get their hands on to support quantitative easing programmes creates a scarcity of bonds, especially since market makers are not allowed to hold as much inventory due to new regulatory capital requirements.”

Partnership approach

Fixed income transitions require that all parties work in partnership to achieve best outcome. “In fixed income, there is much more collaboration between the transition manager, the asset manager and client,” says William Cobbett, head of transition management, Americas, Citi.

The ability to provide such a solution comes from the skill of a transition manager to identify and manage market risk. Each transition manager has a slightly different approach. For example, Cobbett says that Citi’s inventory comes from running a suite of market-making business, which provides certainty of execution costs in advance of trading. “We have invested in technology that allows us to map client portfolios to ETFs to see how they fit and remove a lot of the risk at benchmark prices, converting 500+ bonds into a single ETF holding that you can sell transparently.

“In situations where the client’s holdings might not fit into an ETF perfectly we can plug the gaps with some of our own inventory. In this scenario, everyone wins”, says Cobbett. “The client has transitioned everything at one moment in time at benchmark prices, the ETF manager has increased AuM and we have reduced our balance sheet.”

Transition management may seem a new proposition for fixed income, but it is growing rapidly as investors get comfortable with using the process beyond their equity allocations. “They’re starting to come to us and look to transition managers to more closely fit their needs,” says Jenkins. “As a result this is an expanding, not contracting, market.”

This is particularly true of cross-asset transitions where clients are struggling to move equity into fixed income, or some other combination, he adds. “This area is growing rapidly as clients begin to understand that managing fixed income transitions has become a core concept within transition managers.”


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