Featuring Dan Hines, Senior Fixed Income Trader, ITS, EMEA and Ryan Forberg, Senior Fixed Income Trader, ITS

After the Federal Reserve kept interest rates near 0% for almost a decade, the focus on fixed income is at levels not seen since the global financial crisis of 2008. Currently, fixed income markets are offering desirable yields and better downside protection amid continued economic challenges. Real and nominal yields have risen, and asset allocators are taking note: in an institutional investor survey conducted by BlackRock, four in five respondents said they are making, or plan to make, changes to their fixed income positions, increasing both tactical and strategic allocations.^[1]

With increased focus comes higher volumes, driving managers to seek efficiency gains that provide better access to multiple fixed income asset classes. This drive towards enhanced operating models has encouraged them to consider either replacing or supplementing their current trading set up. For managers that lack access to certain fixed income asset classes, such as investment grade and high yield credit, mortgage-backed securities, municipals, or emerging market debt, outsourcing is a way to quickly ramp up capability.

Fixed Income Managers Search for Better Trading Capabilities

With a changing investment landscape and markets becoming increasingly efficient, it is vital for managers to maintain their edge in uncovering relative value opportunities. The more successful teams rely upon skilled fixed income traders with expertise and advanced technology to reach multiple fixed income sectors quickly and efficiently. However, most asset managers with less than $50B AUM do not have a dedicated fixed income trading desk. Rather, many rely on their portfolio managers (PMs) to select bonds and execute their own trades. There are key reasons why firms may want to look more closely at their trading strategies, including to gain the scale, expertise and governance that larger asset managers already leverage.

Economies of Scale

Trading is a scale business, so having access to a vast network of trading experts, 24/6 trading desk coverage and best-in-class trading venues and technology is vital. A scaled trading desk provides investment teams access to many fixed income asset classes and the ability to execute in multiple markets and regions. This scale can help managers obtain global market liquidity as well as better access to brokers. While a manager may maintain a limited number of broker relationships on their own, a scaled trading desk can offer access to a significant roster of counterparties, globally. As many bonds still trade by appointment, a wider network of execution destinations increases the likelihood of obtaining a better bid or offer and more favorable terms in fixed income transactions. Additionally, leveraging a scaled trading desk with a single point of contact can make it easier to manage more broker relationships, lessening the burden on PMs.

Furthermore, with scale comes advanced technology and infrastructure, enabling better market analysis and contributing to increased efficiency and decision-making. Managers that lack this larger scale capability should re-evaluate their models and consider trading options that provide better market coverage with access to high performance systems and data analytics tools.

Leveraging Expertise

Increased scale not only expands trading operations, it also brings a depth of expertise that managers need to analyze the markets. Understanding how to effectively utilize resources and optimize processes is what makes designated fixed income traders so valuable. For example, during the pricing process, a designated fixed income trader is better equipped to set an accurate price that aligns with current market trends. With their exclusive focus on the trading function, fixed income traders continuously monitor market flows and are knowledgeable of key counterparties and market makers. This deep expertise enables the trading desk to navigate a broader range of fixed income asset classes, helping to increase efficiency.

Another important consideration is the ability to apply the most optimal trading strategy to each situation. For example, a PM that does their own trading may overuse a certain trading strategy because it is the one with which they have the most familiarity. And when trading electronically, the Request for Quote (RFQ) process works for highly liquid names but doesn’t work as well for thinly traded or sensitive orders, such as high yield or emerging markets trades. In another example, “showing your hand" to the marketplace can have adverse effects on execution quality. Dark pool trading is useful to execute orders without disclosing intentions to the entire market and allows the trader to match with the other side of the trade at a specified level. By leveraging the best trading strategy for the order, a PM can expand the portfolio’s potential returns.   

Improved Governance and Compliance

Yet another crucial aspect for managers to consider is the importance of governance and compliance measures. In the equity markets it is generally accepted as good governance to bifurcate the trading and investment decision-making process. However, that separation of duties is frequently not the case for fixed income investment managers, where many fulfill both roles. Having a PM as the designated fixed income trader can compromise the integrity of investment and trading processes and create compliance concerns. Since portfolio managers are responsible for making investment decisions, a potential conflict of interest may arise if they also execute those decisions (a practice which has been regulated in Europe with MiFID II). Combining investment and execution decisions has the potential to impact the impartiality of the trades. As a result, it is good governance for the manager and trader to be kept as two separate functions, implementing necessary checks and balances. Separation of duties also helps reduce key person dependency and the associated risks that come with it, and an execution specialist provides additional expertise to find the best bids and offers in partnership with the PM.

Outsourced Fixed Income Trading Gaining Traction

Outsourcing the fixed income trading desk, while a relatively new concept, is beginning to gain traction amongst asset managers looking to supplement or replace their trading functions. According to a 2022 Northern Trust survey of asset management firm leaders with AUM of $500 billion and below, 60% of respondents said they are more likely to outsource an area of their business.^[2] As fixed income volumes grow, outsourcing allows managers to leverage specialized expertise, scale and advanced technology.

Collaborating with an outsourced service provider increases operational efficiencies and brings a heightened level of expertise and governance to the trading function. It can also help investment firms improve their access to market liquidity and brokers. Additionally, outsourcing the trading function can enhance a firm's governance and compliance, creating a separation of duties between investment manager and trader. It enables investment teams to focus on the value components of their operating models while leveraging greater scale and expertise in the trading function.

[1] Fixed income survey – Institutional | BlackRock

[2] Driving Growth in Asset Management: The Next Chapter (northerntrust.com)