Structured credit: The rise of the structured bond business.
Some people don't know what the "structured' or "engineered' bond business is. Others think the business, after a brief flowering in 1983 and 1984, is withering away. Both groups are in for a surprise.
The structuring of bond portfolios promises to be the dominant feature of tomorrow's bond markets in the US, radically changing the old order.
The men behind this revolution were, a decade ago, teaching mathematics or economics at graduate schools. Now they are fixed-income strategists, and their buzzwords are part of the bond portfolio lexicon-- dedication, immunization, reoptimization, dynamic value matching, dynamic asset allocation.
In his office overlooking Manhattan's East River, one such strategist discussed with glee how the soaring profitability of the structured business has enhanced his stature within his firm. "Quant, number cruncher, computer jock--all the words of derogation are fading now,' he said. "And it's because, without you, they don't know what the hell to do.'
The structured business is a response to a growing feeling among US corporations that active portfolio management, which essentially is a bet on interest rates, is too risky and too unscientific a basis on which to commit billion-dollar pension plans. In other words, the corporations suspect that money managers may not be worth their very substantial fees.
Knowing what to do with America's $1 trillion of pension funds has always been the dilemna of the plan sponsor. Decades ago, bonds were bought and held, and that was it. Then active money management established itself. Many managers showed themselves able to forecast interest rates, and thus add real value to bond portfolios. In the late 1970s, however, inflation and market volatility hammered scores of forecasters. Corporations began to cast about for ways to protect themselves against market vagaries.
The process was accelerated by the appearance of the corporate raider. When the dust from defensive restructuring and takeovers had settled, it became clear that targets had been picked, at least in part, on the basis of their excessive pension fund assets, which could be diverted to the use of the raider.
"It has become clear from restructuring and buyouts that pension assets and liabilities are clearly in play in the economic reality of corporate financial manoeuvring,' said Doug Love, director of research at BEA Associates, a New York fixed-income manager.
As a result, risk minimization has emerged from the shadows of bond portfolio management. "Structured investments are a fact of life,' said Stanley Diller, fixed-income strategist at Bear Stearns. "The pension is part of the corporate business, and has to be managed in a responsible manner--not by cover story charismatics talking about their hunches. You don't put $2 billion on someone's hunches.'
Raiders made clear the inadvisability of overfunded pension plans, and new accounting procedures are showing the undesirability of underfunded plans. In 1987, according to new Financial Accounting Standard Board regulations, pension liabilities will be measured at an interest rate which reflects market conditions. At present they are shown at actuarial rates. The change may make corporations more conservative about risk-taking, or more understanding of pension plan liabilities. Both reactions will encourage more structured methods of investing.
According to Gifford Fong, who is head of his own West Coast consulting firm, nearly every major plan sponsor in the country either has, or is seriously thinking of, the structured approach. "It is virtually universal,' he observed. "Those who don't are quickly disappearing, like dinosaurs.'
The jewel in the crown of structured investments is dedication, also known as cash-flow matching. Tens of billions of dollars of funds have been dedicated since Salomon Brothers, under Martin Leibowitz, doyen of bond strategists, began to market the concept in 1979.
This is ostensibly a one-off structuring of a bond portfolio. It involves matching assets to liabilities by purchasing bonds with cash inflows from coupon interest and maturing principal to match exactly the outlays required by the fund to pay benefits.
Spurred by market rates materially higher than the actuarial rates used to value pension liabilities, sponsors took to dedication in the early 1980s, to lock-in on impressive fixed returns, and thus to boost earnings by freeing pension monies and cutting pension management costs.
"Rates were so high and actuarial benefits were so great that the reasons to get involved were compelling,' said Peter Christensen, who leads the team specializing in dedicated portfolios at First Boston. Today, an estimated $100 billion in dedications are in place, and dealers and money managers are in fierce competition for the prize of handling and trading this huge segment of the market.
Salomon was in the vanguard of the business, but was soon followed by Goldman Sachs, First Boston, Morgan Stanley and others.
When Merrill Lynch Capital Markets set up a risk management group seven years ago in its New York headquarters, its function, according Carl Antenucci, who headed it, was to hedge Merrill's fixed-income exposure. But the group also included an arbitrage and a fledgling structured investments capability. At the beginning of this year, the risk management group was renamed the structured investments group. At Merrill, as elsewhere on Wall Street, the tail has come to wag the dog.
Merrill did $10 billion in structured deals in 1985, more than twice as much as 1984. "The structured business is massive,' said Antenucci. "And it's profitable for us.'
However, just as the structured business begins to hit its stride, dedication shines less brightly. When rates were at 14%, corporations could in many instances cut the amount needed to fund their pensions by as much as a third. But with US long bond rates falling below 10%, and actuarial rates climbing to 8%, the benefits have shrunk.
"There's no doubt you're better off dedicating when rates are higher,' admitted Leibowitz of Salomon. Falling rates are likely to ensure that there will be fewer dedications in 1986 than in the preceding years. There seem to have been fewer in 1985 than in 1984.
The trouble with dedication is what many consider the unnecessary expense of putting together a portfolio. The sponsor pays "for a degree of accuracy in bond selection that is totally unwarranted', said Love of BEA.
Diller of Bear Stearns agreed. "Behind the theory of dedication and immunization is the question of how much accuracy is needed. It's a waste to spend a lot of money to get to the third decimal point. It's like building a car to airplane specifications--that car will rust and be stolen like any other car, perhaps faster.'
Dedication is cash-flow matching; immunization is duration matching. It is considered more flexible, but it too has flaws which have recently emerged. When the relationships between long-term and short-term rates change, immunized funds face mismatching risks.
"All the rule-bound systems have problems,' said Diller. Vendors in the industry are selling software, not philosophies, and as a result, he said, sponsors have been "tantalized by rigour'. He added: "It's like fighting the wrong war very efficiently.'
Yet despite the growing reservations over its two principles--dedication and immunization--the structured bond business continues to grow, surprising even its advocates. "There were many of us who thought that if rates came down the way they have, the structured business would have dried up,' observed Jess Yawitz, whom Goldman Sachs lured six months ago from a chair at Washington University's department of finance to direct its financial strategies group. "But the business hasn't fallen off, and the reason it hasn't is that the mindset that led plan sponsors to dedicate remains intact.'
Plan sponsors are more and more intent on finding more innovative investment vehicles, in the hunt for better returns. Paradoxically, an important element of this new attitude is a conviction that a core portion of a bond portfolio should be conservatively managed, by indexing, for instance. The rest of the assets can then be used for gambles. Leibowitz of Salomon called it an "asymmetric' approach, combining conservatism and aggression. "You control your risk, but you participate in a broad range of assets where excessive returns could be available.'
If structuring bond portfolios makes sense for corporate America, it is a development that delights Wall Street. Through the buying and selling of bonds, Wall Street firms derive as much as half their total profits. Dedications are particularly desirable, allowing the dealer in many cases to get his hands on the pot of pension gold directly, for this is not traditional portfolio management, and there is no need for a manager between broker and sponsor.
This has incensed managers, who have done their best to convince corporations that it was sheer folly to use dealers as both agent and principal in their bond transactions. "When you're asking dealers to buy bonds from themselves, you're setting the fox to watch over the chickens,' said one manager.
The foxes point out that there are clearly circumscribed limits to profiting from dedications. Much of today's structured business is openly competitive. A corporation (or its manager) says roughly which kinds of bonds it wants for its portfolio. Then it gives the business to the dealer that makes the lowest bid.
Merrill officials say that at least half of the structured business they win is aggressively competed for under these conditions. To get this business, it is difficult to build huge profit margins into bond pricing, the argument goes. At First Boston, Christensen said: "Perhaps to get this business you have to price to lose.'
Many structured deals are done overnight. If in the morning the markets open higher, dealers can take a knock when they buy bonds they have promised to deliver, unless they can supply them from their own inventory.
But, as one sell-side strategist noted, the riskier the deal, the more the price reflects it. Merrill's Antenucci, though observing that the firm has priced some deals extremely tight, claimed: "We've never taken a major hit.'
Another danger in the structured business is mispricing. The computer searches through a huge array of fixed-income securities for the cheapest solution that can be found within the quality and duration limits set by the client. Any pricing mistakes are inevitably picked up and included in the computer's solution.
"Optimization relentlessly picks out the worst priced securities,' said Leibowitz. As a result, he added, Salomon learned to develop quality control very quickly. "You have to marry your trading and your computer capability.'
Nonetheless, the multi-million dollar inventories of bonds held by the largest dealers clearly extend the possibilities for profit in dedication and other structured deals. Diller, who set up the dedications capability at Goldman Sachs before moving to Bear Stearns eight months ago, said flatly that Goldman made more money out of one dedicated portfolio than out of a whole year of equity programme trades. Salomon is said to have made profits of tens of millions of dollars from trading when it dedicated Chrysler Corporation's $1.1 billion portfolio in 1984.
In unwarier moments some dealers will acknowledge the potential for profit when a whole programme can be supplied from inventory unrestrained by competition. One head trader called the reoptimization or rebalancing of a dedicated portfolio a "bonanza, like stealing'. He added: "It's like selling a suit to someone and telling him it will last five years. Except, of course, you know that it needs tailoring every year.'
Merrill Lynch executives do not deny the profitability of the structured business. "Once we know we are going to do a deal, we have time to prepare for it,' said Antenucci. "We know what securities will be needed to fulfil a programme, and that allows you to set yourself up for the deal. You can quietly accumulate what has to be done.' He added quickly: "It's cheaper for the customer.'
Antenucci spoke of the everyday bond business where individual orders are shopped around dealers and where margins of "just sixty-fourths' are made. The structured business, said Antenucci, is "different, very different . . . much more profitable'. The day-to-day trading of the firm, according to Antenucci, is losing out to the structured business.
At the big dealing houses, structured deals are already the most active customers of the zero-coupon desks. Apart from the initial trades in a dedication or reoptimization, dealers can profit from the subsequent trading generated by the bonds in the original portfolio, which can be plugged into inventory and used at will.
"In a case where you have a $1 billion order, you become the corporate market,' said Christensen. "The other dealers have to respond, and that gives you an enormous advantage.' Controlling the order flow for a certain type of bond gives the dealer a nearcertain indication of that bond's pricing in the short-term, a guarantee for successful trading.
The largest structured deal was done last July, when Salomon reoptimized, overnight, American Information Technologies Corporation's $2.4 billion dedicated fund.
The next largest, $1.5 billion, was done by Merrill for one of the many funds that prefer to dedicate and reoptimize clandestinely, also in 1985.
In late 1984, First Boston underbid Morgan Stanley to earn the right to reoptimize the American Airlines $1.2 billion dedicated portfolio.
For every billion-dollar reoptimization, there are 20 modest million-dollar deals. With this type of volume at stake, said Christensen, "you can't afford not to be involved in dedications if you want to be a real player in fixed-income trading. Your traders have to know where the bonds are.'
The size of the operations has meant that structured deals have concentrated among a few big dealers. A dealer needs the strategy team to design structured deals, the computer and linear programming ability to go through the possibilities and the trading capability to price and execute massive transactions. According to Andrew Morse, director and head of the corporate desk at Drxel Burnham Lambert, a firm in this business needs government, corporate and mortgage-backed desks, and each of these must rank among the top eight in Wall Street, with the average putting the firm in the top six.
"Others are not precluded, but they'll have difficulty being competitive,' he said. "This is not a limited menu restaurant.'
Recently, capability in the futures market has become important, too.
For money managers trying to get into the structured business, the problem comes in pricing the wide selection of bonds to be included in a portfolio.
"It's critical to have on-line dealer pricing --our traders price thousands of bonds daily,' said Christensen.
A Salomon executive said of the market place: "It's very fuzzy thing until you can say where bonds are and what they're priced at.' To do dedications, he maintained, "you have to be astride the market'.
The halcyon days of huge profits from single deals may be over. "Customers don't stay dumb for ever,' said one fund manager. The second tier of Wall Street firms will not find it any easier to join in.
"Salomon was the first to use sophisticated computer analysis to get the structured business, and they charged significant spreads to cover their costs,' said one trader. "But now that others are trying to get in, spreads are narrowing, so to cover costs volume has to be immense.
Not many firms can handle that scale of trading. According to Morse, in the past six year the absolute number of effective dealers in US corporate bonds has divided by three. It will probably shrink still further.
However, while Wall Street's finest brains have been busy with techniques of dedication, some simpler methods are becoming fashionable.
Some see fixed-income indexing as the most important. This means that portfolios are designed to replicate the performance of the market.
"Last year, as a firm, we emphasized immunization,' said Antenucci of Merrill. "This year the emphasis is on indexing.'
Money managers are not very fond of indexing. It replaces active with passive management, with a resulting diminution of business. And Wall Street feels ambivalent about it, as there are clearly circumscribed limits for sell-side profit. When pension funds are indexed, large-scale execution and transaction costs will ensure only that the fund underperforms the market rather than duplicating it.
However, the order flow will be more than worth the costs. "If index funds climb to a $100 billion business, even though it won't be the most profitable section of the business, Wall Street will scramble to get in on it,' said one trader. "And they'll do it because it's that important to them to know where the business activity is.'
"Because of the chaotic markets, people are throwing in the towel and saying that it's good to be average,' said Morse. "But in a business it is never good to be average.'
However, the move towards indexing has been accelerated by the blatant inability of an increasing number of money managers to perform as well as the market.
The shearson Lehman Brothers International bond index returned an average annual rate of 19% between 1981 and 1985. That was better than two out of every three money managers, according to a national survey by SEI Corporation, a Chicago-based consultancy firm.
As a result, the air is suddenly thick with cries from Wall Street extolling specific bond indices. At the end of last year, Salomon brought out a new index, citing compelling reasons for institutional fixed-income indexing. Does Salomon believe in indexing? A Salomon executive equivocated: "Well, it's one form of being involved.'
Merrill Lynch, which, like Shearson, has had bond indices in the market for some time, reacted by a large-scale advertizing campaign pushing its own. Merrill will construct fixed-income sub-indices at the drop of a hat. "If there is a client who says he wants to match the 15 to 30-year segment of the market, we can say: "Boom, it's done,'' declared Antenucci.
Others are also stirring. There are difficulties with both the creation and the use of a bond market proxy, said Yawitz of Goldman Sachs. But, yes, Goldman is working on developing its own indices.
There are other advantages for dealers to be gained from indexing. One trader noted wryly: "It's amazing how often, when you're long on one particular bond, that bond turns up in the index that you're recommending to your client.'
The word termination is anathema to Wall Street and money managers. It takes their bread and butter and puts it on the table of insurance companies. As a rule, when companies terminate their pension plans, they cover current obligations to their employees by buying annuities.
But purchasing an annuity makes the fund a victim of the credit of the insurer, so dedication has been pushed as an alternative. The problem with using dedication, said Christensen, is that, among other risks, the plan faces a credit risk if any of the bonds in the dedicated portfolio default, and a reinvestment risk for interest payouts. First Boston is now exploring the viability of purchasing an insurance rider against these risks.
The shape of tomorrow's structured business lies not so much in computer systems as in the imaginations of Wall Street strategists. "My work is to find the best structure to suit people's needs,' said Diller. "Technology is not the core of this--it is a philosophical problem, not a technological one.' Gesturing at a blackboard of indecipherable scrawls purporting to clarify an immunization, he added: "Any engineering student, even from a bad school, has the technical ability to do any of this work.'
There is a step beyond linking assets and liabilities--the creation of synthetic securities that will allow funds to lock-in on a spread between assets and liabilities. Such a spread would obviously be better than dedicating for 30 years, pointed out Paul Jacobson, head of Goldman's government and mortgage-backed desks. But he added that achieving such a spread "is commonly tried but not commonly successful'.
Yawitz of Goldman recalled the 1960s, when thrifts bought long-term mortgages and funded them with short-term securities, and were acutely vulnerable to interest rate rises. "If we could have given them an interest-rate option that would have locked them in on a specific interest rate, that would have been a great product, then and now,' said Yawitz.
One technique now starting to affect portfolio management is dynamic asset allocation. A minimum rate of return is guaranteed through an immunized portfolio, and aggressive returns can be sought through equities. The riskiest assets are hedged through synthetic options. The skill lies in creating the synthetic, establishing a behavioural similarity in unsimilar products. "The thing is to find out what it is that constitutes similarity,' said Diller. "We try and fix a framework where apples and oranges both look like pears--and that's what tomorrow's fixed-income market is all about.'
Dynamic asset allocation is the "second game ever invented' that allows dealers direct access to the pension pot of gold, according to Love of BEA. (The first was dedication.)
Because the technique is so transaction-intensive, and because the most efficient way to execute it is in the futures market, it has been eagerly promoted by brokers. Love estimated that about $10 billion in dynamic asset allocation business was already being done. By 1988, he said, it would be easily the biggest part of structured business.
The future holds little joy for dealers unable to make themselves part of the structured business. As multi-billion dollar funds become what Leibowitz called "pro-active,' they need to move rapidly across different types of bonds without disturbance.
In a bond market dominated by structured business, large-scale transactions will become the dominant trading characteristic. "There is bound to be a concentration of trading, and profits will thus be concentrated,' said Gifford Fong.
"Known structured deals are about $60 billion, and unknown deals about the same,' said Antenucci. "That's $120 billion out of a pension fund universe of $1.3 trillion.' He smiled happily. "There's obviously room for enormous growth.'