Large broker-dealers hit fork in road, choose to take illiquid route

Call it a case of the "haves" and "have nots."

Institutional investors that largely trade the most liquid fixed-income securities are getting the cold shoulder from some large investment banks that would rather trade bonds that are more esoteric, less liquid and more profitable.

The end result is that for some broker-dealers, relationships with institutions that trade in large volumes of liquid securities are no longer seen as important, broker-dealers and consultants said. The push now is to strengthen ties with institutions that flock toward derivatives transactions and with hedge funds, which have dived headlong into the opaque world of derivatives.

A study by Greenwich Associates, Greenwich, Conn., shows that a number of broker-dealers are getting a lot more particular about the types of fixed-income trades they handle, especially as spreads in some of the most liquid asset classes continue to narrow. What's more, the bifurcation of the institutional investor community by broker-dealers is becoming much more structured and pronounced, the study said.

"When we talk to certain investors, many of them are communicating that level of change in the market," said Tim Sangston, a Greenwich consultant who helped put together the study, which is based on data collected from 1,281 fixed-income investors. Both the study and Mr. Sangston declined to identify large firms that are de-emphasizing the trading of traditional fixed-income securities.

While Greenwich declined to identify the firms engaging in the practice, consultants confirmed the trend is taking place. Also, Brian Zalaznick, a managing director and head of U.S. fixed-income business at Barclays Global Investors, San Francisco, said his firm is looking to expand beyond traditional fixed-income securities trading.

"You couldn't do this a few years ago, but now with the ability to buy and sell protection (through the expansion of the credit derivatives market), we are building a business," he said.

Officials at a number of bulge-bracket firms, including Bear, Stearns & Co. and Citigroup, declined to comment on the trend.

Mr. Sangston noted that while broker-dealers have long devoted energy and resources toward courting more lucrative clients, and offering products that generate the highest revenue, the Greenwich survey indicates "they are putting a lot more teeth into those strategies." He said that once the most lucrative clients are identified, there is "more rigor around client planning" on the part of some broker-dealers.

And those investors that don't fit the desired profile are feeling left behind — at least by the broker-dealers interested in the more profitable forms of fixed-income trading, the study said.

Securities generating the least amount of excitement among some of the larger broker-dealers are also the most liquid in the fixed-income market. They include Treasury securities, agency bonds, mortgage-backed securities and high-grade corporate debt.

While those types of fixed-income securities have long been the most widely traded, the emergence of an electronic trading market has further narrowed spreads on these types of bonds, which Mr. Sangston and others say has contributed to an acceleration of the bifurcation trend.

According to a number of sources, an increasing number of trades of extremely liquid fixed-income securities move onto electronic trading platforms operated by companies such as TradeWeb, which is operated by Thomson Financial, New York; MarketAxess Holdings Inc., New York; and BondDesk Group LLC, New York. That has only helped fuel the decision by large broker-dealers to take fewer calls from institutions trading in the most vanilla of securities, the Greenwich study shows.

"If you had to pinpoint (the trend of large broker-dealers moving away from traditional fixed-income trades), you might say that it loosely coincided with the advent and growth of electronic trading in fixed income," Mr. Sangston said. "It's the notion of certain products and certain types of accounts becoming less profitable for (Wall Street) as a result of electronic trading, increased transparency and spreads narrowing.

"What it has meant is that clients who either weren't big enough to make those trades worthwhile or didn't have other trades that they were doing that would be profitable for the dealers became less interesting" to broker-dealers, Mr. Sangston said.

Randy Grossman, research manager in the capital markets practice of Financial Insights Inc., Framingham, Mass., said what is happening in the fixed-income arena is somewhat similar to what took place in the equities market.

"As the fixed-income markets become more automated, we will see the same reaction as we are seeing in the equity markets," Mr. Grossman said. "Firms have basically, to a large extent, written off equities as a profit center."

But while an increase in the number of electronic trading platforms in the fixed-income area is spurring some broker-dealers to abandon the most liquid fixed-income asset classes, few believe all broker-dealers are set to ignore traditional bonds entirely.

Mr. Zalaznick of BGI remarked that the presence of large pension funds, which are restricted from investing in overly opaque securities, means there will remain a market for traditional fixed-income securities.

"There are a lot of legislative restrictions around what they can invest in, including restrictions on derivatives and shorting," Mr. Zalaznick said.

What's more, Greenwich's Mr. Sangston pointed out, as large firms move out of the traditional fixed-income market, it is creating opportunities for other broker-dealers, particularly those with international headquarters, to move in and grab some of that business as they look to build market share. Among the firms stepping in are HSBC Securities and BNP Paribas.