Regulators should be wary of disrupting debt capital markets

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“Sorted that allocation 4 u, big boy”. Is this the kind of email from a syndicate manager or fixed-income salesman at one of the leading bond underwriters to a favoured investor client that we can look forward to sniggering over?

After US supervisors launched enquiries into allocations on some of the big corporate bonds last year, such as Verizon and Apple, Euromoney learns that regulators in Europe and the UK have been asking banks to walk through the processes behind allocations to investors in selected bond deals.

It’s an inevitable consequence of bull markets that as new issues start to get heavily oversubscribed, participants game the system. Some investors over-inflate orders, anticipating that they will be scaled back on allocations to particularly juicy transactions. Others complain that they are being squeezed out unfairly and that lead banks are favouring particular investors that pay them the most money.

This has been coming to a pitch. There has been more money looking to go to work in bond markets than there are opportunities to invest. Deals offering any yield are being seven, eight, nine times oversubscribed.

BIG BOND SQUEEZE
The big bond squeeze

While large amounts of money are being allocated to fixed income it is almost impossible for asset managers to put this to work in the secondary markets when none of their peers want to sell and dealer balance sheets are shrunk to a tiny fraction of the market compared with before the regulatory onslaught. Almost the only chance investors have to put money to work is through new-issue allocations.

At the same time, consolidation in the asset management industry has led to the emergence of firms with hundreds of billions and even trillions of dollars of assets under management and some very large individual funds. Following poor performance and the controversial departure of co-CIO and CEO Mohamed El Erian, Pimco’s Total Return Fund had suffered 12 consecutive months of outflows by the beginning of May. Clients withdrew $55.26 billion. That is nearly equivalent to the entire assets under management of UK fund manager Man Investments as at December 2012 ($57 billion). And even after a near 19% fall, the world’s largest bond fund still has $230 billion under management.

Such giant funds regularly submit very large orders for new issues, sometimes as big as the deals themselves. These are inevitably among the biggest customers of banks’ secondary sales desks, the biggest payers of spread and commission, and they expect recompense for their buying power. How these investors are allocated in primary is a topic they are keen to discuss with banks at regular meetings to review how much they pay to banks and what service they receive.

So it’s not surprising that funds that miss out on allocation grumble that lead banks favour their biggest customers. Adding to the echoes of previous malpractice in spinning equity new issues, this comes when certain bond deals have seen prices rise in the aftermarket by several percentage points, offering big and speedy returns to those lucky enough to be allocated. Hence there are calls for more fairness and transparency around how new issues are shared out.

Dark art

Regulators should indeed take a close look at this. But they should also reflect on whether attempts to impose fairness and transparency on what looks like the dark art of new-issue allocation risk disrupting a crucial funding market.

It was back in 2008 and 2009 that those big bond investors had the chance to dictate pricing, when banks stopped lending and other investors pulled back. Right now, they can’t impose terms because of abundant competing demand from smaller investors. Borrowers and lead banks have an obvious motive to feed this demand with some allocations. And if smaller investors, hedge funds and private banks for example, are allocated a lower proportion of what they submit for, that might be because they are more likely to over-inflate orders than conventional unlevered asset managers.

Any allocation process requires discernment between which investors are more desirable to hold a bigger share of new issues. Doing away with such judgment would turn new issues into simple auctions with pro-rata allocations. That might lead to less orderly secondary markets that might damage both issuers’ and investors’ interests.

Bookbuilding and syndication entails judgments about the most appropriate holders for a borrower’s debt that any who miss out can call unfair. But the process works well enough that most European government debt offices turned to it during their own funding problems.