Agency brokers offer new hope for bond market liquidity

INVESTMENT BANKS ARE riven by fear – the reason why managers have removed virtually all risk from their bond trading desks. Not that they have much capital to support risk-taking anyway. But amid the gloom and dislocation, there are at last signs of organic repair in the debt markets.

This is not a government-sponsored initiative to fix some broken aspect of the financial market. Agency brokers are returning to the debt markets, a development heralded as a return to the primacy of relationships. These brokers aim to reconnect investors with each other, offering access to dark pools of liquidity that undoubtedly exist but at present cannot be easily tapped.

“We are really busy!” says Guy Cornelius, head of fixed income at Evolution Securities. “Of course the volumes are a fraction of what we used see at a full-service investment bank but these are very early days.” As the man charged with leading a bold expansion at the boutique operation, Cornelius can hardly contain his excitement at how well the business is already going. He worked at UBS for most of his career before joining the doomed Lehman Brothers in 2006. He was recently offered a senior sales role at one of the few investment banks to come through the crisis relatively unscathed but instead chose to join Evolution.

His decision is understandable – his firm is in expansion mode. He is already halfway to achieving his target of hiring nearly 40 sales people. It is a stark contrast to what is taking place at the investment banks, which are implementing savage cutbacks. For example, one large US firm is rumoured to be cutting the 140-strong credit sales team by nearly 100. A similar process is taking place at many dealers. It is no surprise then that agency brokers’ phones are ringing hot because in addition to the prospect of a job, they are offering the best salesmen top compensation packages.

It is a remarkable and exciting development because agency brokerage has not been a significant business in fixed income since the late 1980s. Its demise was brought on by the evolution of the investment banks into the equivalent of financial services supermarkets. Agency brokers were no longer needed when the investment banks changed from having a generalist sales model to becoming specialists. Banks not only had their balance sheets but in-house sales expertise too. Once access to new issues and research was added into the equation, the large dealers had key sell-side relationships locked up. They took on investing customer business as principals, not agents working on commission. But that market-making model now lies broken.

“I’ve spoken to quite a few sell-side firms about this; there is no doubt about it – their balance sheet secondary market trading has been curtailed,” says Mike Zelouf, director of London business at Western Asset Management, a wholly owned affiliate of Legg Mason. “It’s not something that they are committed to in the way they have been in the past. They are withdrawing as a group and as one house – a large UK counterparty of ours – said ‘liquidity begets liquidity’.”

William Frewen, head of fixed income at Threadneedle, says: “There has been a total change with the investment banks. They haven’t got much capital, [and] they’re allocating their capital where they think it’s most useful.”

That’s not to secondary bond market trading, so alternative entities – even though they are light on capital themselves – now have a potentially vital role to play.

“Traditionally fixed income has been a capital-intensive business. You could only participate around the periphery unless you were hugely capitalized and prepared to put that capital at risk,” says Iain Baillie, head of fixed income at Christopher Street, where he is ramping up the agency brokerage business.

This is something of a second coming for Baillie, who was a founding partner in Luthy Baillie Dowsett Pethick – a sterling bond agency brokerage boutique that operated from 1990 for six years before being bought by Dresdner Kleinwort Benson. Christopher Street is owned by inter-dealer broker GFI, and, thus far, is the only example of an IDB taking a positive view on the agency brokerage business (Icap’s Butler Securities limits itself to the gilt market). Baillie has longstanding and strong relationships with the buy side, particularly in the UK, and is certain that there is an opportunity for firms like his.

This is not a temporary hiatus in typical trading relationships – secondary liquidity has been absent since August 2007. Because there has been a sustained breach in the liquidity that is available in the fixed-income secondary market the connections between the various types of investors are now minimal.

“In the old days you could take positions in corporates, any kind of paper, because you knew there would be hedge funds, CDOs, CLOs doing basis trades between CDS and cash. Everybody is one way now, sell positions and unwind,” says Zelouf.

In addition to the market-based selling pressures on levered investors and dealers, regulatory constraints are also appearing. The UK’s Financial Services Authority recently announced a consultation paper that puts out more stringent risk management procedures on liquidity. This is likely to limit the possibility of turning back the clock on liquidity assigned to trading desks.

“One of the reasons why there has been so much interest in the agency broker model is because most of us are under severe pressure to deleverage,” says a banker. “And there is no question that we are also under pressure by our regulators to reduce capital for taking down positions.” 

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