pimco

Is the bond market rigged?

March 6, 2014: 5:00 AM ET

Big IPO-like spikes, clients being favored over others, and the potential for unfair Wall Street profits. This certainly sounds like another manipulated market.

140121113103-goldman-sachs-620xa

FORTUNE -- Wall Street may have a new debt problem.

Late last week, Goldman Sachs (GS) disclosed that regulators are probing how it allocates and trades bonds. Citigroup (C) is reportedly in regulators' crosshairs as well, along with the rest of Wall Street. At issue is how banks decide who gets to buy into bonds when they are initially offered.

Take last year's massive Verizon deal (VZ). Wall Street dealers received orders for $100 billion in bonds. Verizon sold $49 billion, with about a quarter of that debt going to two firms, bond-fund behemoths BlackRock (BLK) and Pimco. Understandably, some feathers were ruffled. And this appears to be what the Securities and Exchange Commission and potentially other regulators are looking into.

MORE: 4 reasons the gold market looks super shady right now

But is this really a job for regulators? It's not surprising that a good chunk of a hot deal would go to Wall Street's two bond powerhouses. Their size means they pay a large percentage of Wall Street's commission. And even some of those unfairly treated managers seem to accept the situation:

Mary Talbutt, portfolio manager and trader at Bryn Mawr Trust Co., which oversees about $1.4 billion in fixed-income assets, said she put in an order for about $1.5 million of Verizon bonds but didn't receive any. She said she didn't really have a problem that larger funds got more bonds, noting that is just how capital markets work.

"I've been doing this for so long that you just kind of get used to it," she said.

But there could be something else at play here.

Most bond deals start with the distribution of an offering document, which includes info about the selling company and a credit rating. Bankers then call up or e-mail bond managers, like BlackRock or Pimco, and ask them how much they would buy and what they would pay (or what yield they are looking to get). Underwriters then use that information to determine how to price the deal, you would assume at the lowest interest rate they can get that will allow them to place all the debt that the company is hoping to raise.

The problem, as you may have suspected by now, is that it doesn't go down that way. Two years ago, Barclays' credit research team, headed by Jeff Meli, took a look at investment grade corporate bond offerings and found that, like IPOs, bond deals tend to have pops. On average, the price of a newly issued bond rises 0.14 percentage points more than similar existing bonds between the time it is first sold to when it's added to the Barclays Aggregate Bond index, which happens on the last day of the month in which the deal came to market. What's more, more than half of the price increase happens on the first day. That means there are a whole bunch of investors not getting a piece of bond deals that would be more than willing to pay more than the initial asking price. Peter Tchir at TF Market Advisors appears to have done some similar research getting similar results.

MORE: Is Facebook overvalued?

A bond manager who is able to get in on every new issue could expect to outperform his rivals by 1.05 percentage points, the Barclays authors assert. Considering the average yield in the corporate bond market is around 3% these days, that advantage is sizable. All of this suggests that Wall Street is paying off one client with money from another. Corporations sold $1.1 trillion in investment grade bond deals in 2013. That means bond investors who got first access to these deals pocketed nearly $12 billion that could have stayed in the accounts of borrowers, creating a pot of money that potentially Wall Street is rationing out to its best customers presumably in return for more trades later.

Some suggest that an investigation into underwriting practices could pose a problem for Wall Street as bond sales are rising while regulators are cracking down on trading. But that misses the point.

Wall Street firms still make far more money on their bond trading desks than they do from underwriting fees, even if that spread is narrowing. Goldman, for instance, generated $2.4 billion from debt underwriting in 2013. But it got $8.7 billion from its fixed-income trading business, which also includes commodities and currency trades. So you could see why Goldman would be willing to stiff its underwriting clients to keep its trading business flowing. And among the biggest banks, Goldman probably has the least to lose in the underwriting business -- it's ranked sixth in investment grade corporate bond fees in 2013 -- and the most to gain in its trading business, which could explain why it is the first to come under investigation. Citi, too, ranked behind JPMorgan Chase (JPM) and Bank of America (BAC) in investment-grade bond deals.

So why is this being investigated now, when these practices have probably gone on for a while? For one, with interest rates at all-time lows, bond investors are complaining louder about the unfair edge that the bigger players enjoy. For the same reason, the stakes of getting into prized deals like Verizon's, which yield slightly higher interest rates. Also, as too-big-to-fail banks have gotten even bigger since the financial crisis, it may be harder for corporate borrowers to take their business elsewhere if they feel like they are getting a raw deal.

MORE: Without immigration, U.S. economy looks worse than Europe

While the preferential treatment to big bond funds may seem unfair, it's unclear it's illegal. Matt Levine seems to think there are a number of plausible and legit reasons certain bond investors get preferential treatment. Corporations might value placing their bonds in the hands of a fewer large bond managers. But the fact that prices are rising suggests there is buying and selling, and issuers probably end up with a jumble of investors anyway.

What's more, underpricing deals is accepted in the IPO market and, after the Facebook (FB) debacle, practically encouraged. After the IPO boom of the late 1990s, Wall Street firms were fined and sued for manipulating IPO offerings. But the fines were small by today's standards. Goldman and Morgan Stanley (MS) paid a $20 million fine each. And Wall Street firms collectively paid $586 million to settle a class action suit on the matter.

In the class action, regulators gathered evidence that Wall Street firms were receiving higher commissions or other forms of kickbacks in return for giving certain investors special access to rigged IPOs. That would be much harder to prove in the bond market, where commissions are often built into the price that investors pay for their bonds, and the market in general is much more opaque. On top of that, few individual investors directly buy bonds, so drumming up resources inside the SEC or another agency might be tough, especially when the impetus of the investigation appears to be one part of Wall Street complaining about another.

All this suggests that we're not really all that likely to see a crackdown of Wall Street's shady bond underwriting practices, even if one is actually deserved.

  • What will tapering do to Treasuries?

    Will tapering be a "sell the news" moment for 10-year yields? The pundits don't seem to agree.

    By Daryl Jones, Hedgeye

    FORTUNE -- Like many Americans nowadays, I tend to tune out much of the mainstream media, but I did catch myself watching a little CNBC recently. Interestingly, it made me realize that the buy side, sell side, and media are arguing with many of the same platitudes on the topic MORE

    Dec 12, 2013 9:08 AM ET
  • Bond kings face dismal 2013 returns

    PIMCO's Bill Gross and the other big bond boys are experiencing some performance issues this year.

    By Daryl Jones, Hedgeye

    FORTUNE -- For those of you who missed it in high-school history class, Sir Ernest Shackleton is the best-known figure in the "Heroic Age of Antarctic Exploration," which began in 1911 after Roald Amundsen successfully reached the South Pole. Shackleton was a maverick. He wanted to one-up Amundsen. So he set MORE

    Nov 26, 2013 10:04 AM ET
  • The great ETF mega-war

    Vanguard is challenging BlackRock and State Street for dominance. It's a battle of titans - and investors are the winners.

    By Erika Fry, reporter

    FORTUNE -- Vanguard rose to the pinnacle of the mutual fund world with a simple but potent formula: an emphasis on low fees and index funds. These days Vanguard is applying that same philosophy to a fast-growing sector of the investing universe already built around low-cost indexing: MORE

    Jan 29, 2013 5:00 AM ET
  • PIMCO's El-Erian: We're very worried about the fiscal cliff

    Bond fund chief says if Washington doesn't do something, our kids will be worse off.

    FORTUNE -- PIMCO, the huge asset manager, has mapped out a contingency plan for what to do with its clients money should the U.S. go over the so-called Fiscal Cliff.

    Speaking at FORTUNE's Most Powerful Women Summit on Wednesday, PIMCO's CEO Mohamed El-Erian said the U.S. economy will certainly collapse into a recession if Congress does nothing MORE

    - Oct 3, 2012 6:32 PM ET
  • Rob Arnott is going abroad for growth

    His strategies are used to manage $100 billion - and he's seeing hopeful signs in emerging markets.

    FORTUNE – Rob Arnott is one of the few major investors who buys and sells almost any asset anywhere in the world. Not only does he manage Pimco's $27 billion All Asset Fund (PASAX), but as chairman of Research Affiliates he has also devised strategies used to manage $100 billion. Arnott is the father MORE

    - Jun 4, 2012 5:00 AM ET
  • Bill Gross says it's time for investors to plan a "Great Escape"

    Bond king Bill Gross says it's time to get your portfolio ready for a long-period of lower market returns.

    FORTUNE -- Apparently, Bill Gross picks movies as well as investments.

    Bond investor Gross, who runs the world's largest mutual fund Pimco Total Return (PTTRX), is known for his quirky letters to investors. In the past he has dispensed love advice (specifically for Europe) and written about why he hates automatic flush toilets.  MORE

    - Mar 28, 2012 5:00 AM ET
  • The end of mutual funds is coming

    Pimco is launching an ETF to track the biggest mutual fund, its Total Return Fund. Will this portend the end for mutual funds? We looked into the future to find out, and this 2022 story tells it all.

    By Joshua Morgan Brown, contributor

    March 1, 2022

    FORTUNE -- Ten years ago, in March of 2012, the world's largest mutual fund cloned itself as an ETF. It occasioned a small amount of business media MORE

    Jan 24, 2012 11:13 AM ET
  • Repression and memory at Pimco

    The guys at Pimco are letting their imaginations run a little wild.

    First Bill Gross called for a bond market turkey shoot and bet against U.S. government bonds just before they staged a big rally. Now one of his functionaries, portfolio manager Scott Mather, is warning about "financial repression."

    That sounds vaguely Freudian, though it actually refers to the process of holding down interest rates to help pay down ridiculous government debt loads. MORE

    - Jun 20, 2011 4:28 PM ET
  • Gross boosts wrong-way bet on a bond crash

    A little Treasury rally doesn't faze the loquacious bond bear Bill Gross.

    Gross, the manager of the world's biggest bond fund, increased his bet against U.S. government debt last month while adding to his record cash position – even as bond prices rallied.

    Gross' Pimco Total Return fund held 43 cents of cash for every dollar it had in assets, according to data from the end of April (see chart, right). That's MORE

    - May 10, 2011 10:31 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.