When a corporate bond sale draws 10 times as many orders from investors as the amount of debt available, how do you decide who gets what?
It’s an issue with which bond syndicate bankers grapple on a daily basis. But from January their decisions will face much more scrutiny under the EU’s Mifid II regulation, sweeping new rules that aim to improve transparency and fairness across financial markets.
Under Mifid II, bankers must provide a justification for the final allocation made to each investor in a bond sale. This piece of the regulation attempts to address complaints from small investors that banks managing bond sales favour the world’s largest asset managers, handing them more debt as a quid pro quo for fees provided from other business.
But Mifid also has rules designed to protect retail investors that could stop bankers allocating bonds to the smallest investors entirely.
Ruari Ewing, a senior director at capital markets trade association ICMA, said that these “product governance” rules are “the single biggest challenge Mifid poses to bond syndication”.
“The rules are written for the retail structure products market, where they work well, but they are conceptually difficult for vanilla bond syndication,” he said. “The most likely effect is that syndicates will firewall most deals from retail investors – which is easier said than done.”
The problem is that Mifid II requires the creation of a three page information document for retail investors, summarising the potential risks of a deal. But an offering memorandum for a corporate bond usually runs to hundreds, and sometimes even thousands of pages, in an attempt to cover all potential legal liabilities. Cramming this into a few pages would be impossible, leaving banks open to lawsuits if a deal goes wrong.
Most institutional bond sales require a minimum investment of €100,000 to take part, far beyond the reach of even relatively wealthy high street investors. But one head of investment grade bond syndicate at a European bank said “high denominations will not cover you”, and bankers would need to make sure that institutions were not placing orders on behalf of high-net-worth-individuals for example.
For large institutional bond buyers meanwhile, the tension over the allocation process has only heightened as secondary market liquidity has dried up. This has made investors increasingly beholden to the primary market to source debt, meaning that order inflation — where buyers bid for more bonds than they actually want — has become rife as a consequence.
Syndicate bankers already follow strict internal guidelines to navigate these tricky considerations. And banks are in the process of developing drop-down menu systems and automatic record keeping mechanisms, to help meet the new rules without causing major disruption to the constant flow of primary bond business.
But many bankers complain that it’s very difficult to summarise decisions made under time pressure in a format open to regulatory scrutiny.
“I think, unfortunately, it’s going to become more commoditised,” said one corporate bond banker, arguing that most investors will simply get a set allocation based on what type of fund they work for, rather than their engagement with the deal process.
The new rules on allocation could pose the biggest challenge to European high-yield bond sales, which follow very different conventions to the investment grade corporate market.
In European investment grade bond syndications, the bookrunners all take orders and then collate them at the end, removing any duplicated orders in a process called “reconciliation”. They then host an allocation call to debate and decide which investor gets what.
But the high-yield market largely follows a US convention whereby a “left-lead” bookrunner effectively controls the deal. Their bank is listed first on the left in the bookrunner list, with the remaining banks “on the right” listed in alphabetical order.
“When you have six banks openly discussing allocation, liability is split,” said the investment grade bond syndicate head. “But when you have one bank on the left, they’ve got to take full responsibility for how the book is allocated. That’s going to be a very uncomfortable position to be in.”
High-yield syndicate bankers are also more liberal with the zero button – routinely handing investors no bonds whatsoever. One high-yield bond banker said that sometimes up to 40 per cent of the accounts in a book can get zeroed.
But they said that this is because when a bond sale gathers momentum, a flood of small brokers often pile into the book just before it closes, in a bid to get bonds that they can “flip” at a higher price in the secondary market.
“We want to place the bonds in safe hands for the issuer’s benefit at the end of the day,” the banker added. “Will the drop down have a ‘Spiv’ option? Because that would be really useful!”
Perhaps the biggest problem with the new regulation is that it fails to recognise a fundamental fact of the bond market — that syndicate bankers do not have the final say on allocation, the issuers themselves do.
“Most treasurers took a quick look at the final book and sign off on it,” said the corporate bond banker. “But some really do get involved in the allocation process. And it is the issuer’s book at the end of the day.”