Fixed Income Lacks Performance Benchmarks

Terry Flanagan

As the fixed income landscape undergoes transformation brought on by regulatory reforms, financial institutions are faced with the problem of measuring trading performance in the absence of an established benchmark.

“In the OTC markets today, there isn’t even a centralized data repository,” said Isaac Chang, head of the fixed income trading business at KCG. “What are you benchmarking yourself against? What does good execution mean? In equities, everyone does TCA because there’s a tape, so you see every print.”

Chang says that the changes brought on by new regulations such as Basel III, the Volcker Rule, and the Dodd-Frank Act have had a profound impact on the way that fixed income securities get traded.
“The fixed income market traditionally has been a dealer-centric over the counter market,” he said. “The general model has been bank dealer desks are the primary market makers. Banks have been the primary source of origination, both on the credit side as well as in the auctions and syndicating government debt. Banks have always been at the center of the marketplace. With all the regulatory requirements, however, you’re starting to see banks pull back from the marketplace.”

Institutional investors are making sweeping changes to their fixed-income portfolios in response to the post-crisis regulatory changes in the bond markets, current interest-rate environment and expectations of future rate increases, according to a report by Greenwich Associates.

As a result, fixed-income exchange-traded funds (ETFs) are poised to take on a bigger role in institutional portfolios.

“As institutions move to shorten duration and find new sources of yield, current users of fixed-income ETFs expect to increase their use of the product and some non-users will elect to employ ETFs in implementing their portfolio strategies,” says Greenwich Associates consultant Andrew McCollum.

Institutional investors experimenting with fixed-income ETFs quickly begin increasing their use of and allocations to these products. About 60% of the institutional ETF users participating in the Greenwich study allocate more than 10% of fixed-income assets to ETFs, including almost one-third allocating between 10% and 30%.
One-third of institutions now using ETFs say they plan to increase their investments in these products in the next 12 months, including 43% of investment managers and 38% of institutional funds. While most current users expect to increase allocations to ETFs by 1-5%, a quarter plan increases of 6-10% and about one-in-10 expects to boost ETF investment by more than 20%. One-in-five non-users plan to start investing in fixed-income ETFs in the coming year.

Institutions indicated their top application of fixed-income ETFs is a strategic one—to obtain passive exposures in the core component of core-satellite portfolio constructions. With a strategic application already emerging as the most-cited fixed-income ETF use case among institutions, the evolution from tactical to strategic use appears to be taking place even more rapidly for this asset class, perhaps due to the challenges to investing in fixed-income secondary markets.

The institutions cite ease of use, liquidity, quick access, single-trade diversification and lower trading costs as main benefits to employing ETFs.

When it comes to selecting an ETF provider, pricing represents a key driver. Thirty-eight percent of institutions name “better pricing” as one of the three most important factors considered when selecting an ETF provider. The next closest factors are “liquidity” and “breadth of product offering,” which are named as the top consideration by about 21% each.

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