European Fixed Income: Institutional Strategies for the Hedge Fund Era
( Greenwich Associates )
(December 20, 2006)
Wednesday, December 20, 2006 Greenwich, CT USA -With hedge funds generating a growing share of the trading business in many fixed-income products - and a majority of the volume in several especially lucrative products - global and pan-European banks are honing their strategies to focus on these increasingly profitable customers.
The results of Greenwich Associates 2006 European Fixed-Income Investors Study suggest that, as Europe's fixed-income dealers devote more resources and attention to hedge fund clients, traditional long-only fund managers risk losing out on research, liquidity and other valuable sell-side services. A new Greenwich Report presents the key findings of the research study.
Many of the institutions participating in Greenwich Associates' 2006 research expressed uneasiness about what they perceive to be a troubling situation. European institutions are under considerable pressure to generate robust investment returns to keep pace with mounting pension liabilities or other business demands. However, mark-to-market accounting rules and other regulatory issues are providing new incentives for institutions to maintain relatively high allocations to fixed income, as opposed to higher yielding but more volatile equities. At the same time, the flat yield curve and the relatively low interest-rate environment have made it tough to make money in fixed income.
As a result of these pressures, institutions are being prompted to move into structured fixed-income products, high yield, emerging markets or other asset classes that promise greater returns, and of course, greater risks.
In particular, the institutions interviewed by Greenwich Associates this year voiced concerns about credit risk, the potential for credit defaults and the delivery, settlement and other risks associated with the booming credit derivatives business. As Greenwich Associates consultant Frank Feenstra explains: "When and if their concerns about risk are borne out, investors will be relying on the strength of their dealer relationships for the liquidity, coverage and support needed to withstand a downturn. Unfortunately, it is precisely these sell-side resources that are becoming more difficult for some traditional long-only fund managers to secure as hedge funds expand their reach."
Best Execution: More Than Price Alone
Although hedge funds are not quite the powerful force in Europe that they have become in the United States, they nevertheless represent a significant presence in European fixed-income markets. Hedge fund trading volume in cash bonds and derivatives more than doubled from 2005 to 2006.
While fixed-income dealers would gladly lavish attention on hedge funds on the basis of sheer trading volume alone, there is another reason that hedge funds are so appealing to the sell-side: they are less price sensitive than fund managers, many of which feel a fiduciary responsibility to rigorously enforce best execution rules. "Despite some suggestions, regulators must ensure that they do not draw too narrowly the definition of what constitutes best execution in fixed income," says Greenwich Associates consultant Peter D'Amario. "In light of this ambiguity, we advise European institutions not to hamstring themselves by adopting and enforcing an overly narrow definition of best execution. In fixed income and equities as well, best execution encompasses much more than price."
Derivatives and Agencies Drive Fixed-Income Trading; E-Trading Grows Steadily
Overall European fixed-income trading volume - including cash bonds and derivatives - increased approximately 8% from 2005 to 2006. Almost all of last year's growth can be attributed to dramatic increases in trading volume in credit derivatives and a 40% jump in agency security trading volumes. "Credit derivatives trading volume among European institutions nearly doubled from 2005 to 2006," says Greenwich Associates consultant Giovanni Carriere. "At the same time, trading volumes in cash credit bonds were essentially flat."
Among all European institutions, the proportion telling Greenwich Associates that they trade bonds electronically increased from 39% in 2005 to 44% in 2006. Another 8% say they are "considering" the e-trading option, while 48% say they do not plan to trade bonds electronically at any point. "Among institutions with more than $50 billion in annual fixed-income trading volume, the share using e-trading systems jumped from 62% in 2005 to 84% in 2006," says Greenwich Associates consultant Woody Canaday.
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Greenwich Associates is the leading international research-based consulting firm in institutional financial services. Greenwich's studies provide benefits to the buyers and sellers of financial services in the form of benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with additional offices in London, Toronto, and Tokyo, the firm offers over 100 research-based consulting programs to more than 250 global financial-services companies. Please contact us for further information or to arrange an interview with one of our consultants. You can visit our website, www.greenwich.com, for more information.