that the greatest returns are to be achieved and the largest positions found. Not surprisingly, it is also where the greatest losses appear from time to time. Why? Because bond markets are scaleable and open to bulk trading, enabling the highly aggressive and ambitious IBs to put on trades by the billions.
Standing aside from the proprietary trading activities of the investment banks, these organisations have two important roles to fulfil. The first is issuance. New bond issues, sometimes known as the primary market, is the meat and drink of the investment banking industry. Major borrowers need to issue large amounts of bonds, and to do so regularly. This business is fee-generating for the IBs, and repeatable. In addition to the fees charged by the IBs (perhaps 0.4% of the sum raised on a ten year bond), there is a considerable amount of additional revenue that can be generated from offering hedging or related swap contracts, both to the issuer and the buyers of the bonds.
The bankers will constantly be scanning the financial markets looking for opportunities, and pitching deals to their client base. Primary bond market activity is one of the most hotly contested activities in the financial world and the league table of issuance is closely followed each year. Here’s how 2010’s league table for the sterling market panned out, according to Bloomberg.
Table 3.1: ranking of investment banks in sterling bond market (2010)
It is worth pointing out that the sterling market is a relatively small pond. The top underwriter in Euro-denominated bonds issued a volume of EUR79 billion.
Euroclear
Custody is not a subject that receives much attention in the financial press, but you might be surprised how often the subject arises amongst market professionals.
When an investor buys a bond, his broker will need to settle the transaction. Domestic bond markets, such as gilts, have settlement systems that were in many cases established before the dawn of time. However, the majority of corporate bonds, including sterling corporate bonds, are Eurobonds – a type of instrument that has a distinct structure and settlement systems.
The history of the development of the Eurobond market (in the late 1960s) is based on bearer bonds. As the market developed, it became clear that some form of centralised custody system would be needed to enable the speedy transfer of ownership without the need to physically move piles of bearer certificates from one vault to another.
To meet the custody and settlement needs of the growing Eurobond market, JP Morgan established Euroclear in Belgium in 1968. The system proved to be an enormous success and Euroclear remains the hub of the international bond markets and turned over a remarkable EUR451 trillion in 2006.
The Euroclear system has come a long way from its Eurobond roots in the sixties, and now provides a settlement system for numerous classes of securities. However, it is with Eurobonds that most people associate the system.
The system works on a delivery vs cash basis. All bonds are lodged centrally. Nowadays the bonds are typically represented by a single certificate and most investors and their brokers will never actually see or lay hands on a physical certificate.
Banks, brokers and custodians will then hold accounts with Euroclear. When a trade is to be settled (typically between one and three days after the trade), each counterparty will place his or her instructions, either to deliver the bonds or to pay the cash consideration. On the relevant settlement date, Euroclear will then debit the respective cash and custody accounts accordingly.
UK investors may also encounter their bonds being delivered into the UK’s Crest system. We will deal with this in more detail in chapter 15.
Tip
All bonds are held by professional custodians – in Euroclear, via Crest or in the US DTC system. If you are ever approached by anyone offering you bonds, or claiming to hold bonds, outside of these systems, give them a very wide berth.
Brokers & intermediaries
The majority of bonds are dealt on a peer-to-peer basis. That means that one principal (typically an investment bank) will sell a block of bonds on to a customer, perhaps a fund manager or a bank or building society treasury. In the equity market, there is a fairly clear differentiation between the buy side companies (fund managers such as Fidelity, Legal and General etc.) and the market (i.e. brokers and traders grouped around the stock exchange or other trading platforms). Not so the bond market, where many shades of grey exist. Operating within this multi-layered world of banks, proprietary traders, insurance companies, money market funds and investment banks exist numerous bond brokers – often operating in specialised fields. In the manner of a Victorian naturalist, I have attempted to break down the taxonomy as follows:
Investment banks: The top of the tree amongst the numerous bond market intermediaries. The investment banks are the main players and will issue bonds on behalf of the borrowers. The IB’s hold positions in bonds, make secondary markets and sell to brokers and institutional investors. They will also be active in buying bonds and repackaging the debt through the use of swaps, derivatives and other financial engineering.
Bond brokers: These deal in bonds but do not take positions in the bonds. Unlike stockbrokers, who act as agents on pre-agreed commission rates for their client, bond brokers usually take a turn; introducing a margin between buy and sell orders. Usually, bond brokers (sometime known as agency brokers) will sit between the street, as the collection of market makers is known, and the client, who will hopefully be fund manager or other end-investor.
Inter-dealer brokers: As above, but specialised wholesale brokers who work on shifting large blocks of bonds and other instruments between major players (mainly investment banks).
Broker-dealer: A broker who will take some positions, either to facilitate a trade or for speculation.
Stockbrokers: Retail-facing organisations offering private investors access to the financial markets. Stockbrokers vary from low cost online execution-only platforms to high-end discretionary wealth managers. As the name suggests, stockbrokers are typically focused on stocks, and to some degree funds. However, many stockbrokers are now responding to client demand and offering direct trading in bonds. It is through a stockbroker that most private investors will gain access to the markets.
IFAs (Independent Financial Advisors): The typical UK IFA deals with packaged funds and has comparatively little involvement with direct investment into the financial markets.
A day in the life of a broker-dealer
I asked Oliver Butt, a partner in the illiquid and distressed debt specialists, City & Continental, to describe a typical day at their offices on Lombard Street in the City:
“Most of my customers and also ourselves, for our own book, are interested in bonds with high returns or a good chance of substantial capital gain. These bonds require more thinking about than the run of the mill ‘safe’ corporate bonds.
Therefore I begin the day by trawling through messages I get from the market – and by this I mean the bond dealing desks of banks, investment banks and other brokers.
I receive maybe 200 such messages a day in the form of email or the Bloomberg message system (effectively an electronic
