Asset allocation refinements and investment manager changes heighten the challenges of moving bond portfolios.
Transition management services are increasingly used by institutional investors as they shift funds between asset classes or from one investment manager to another. In many cases, this activity is tied to rebalancing required to bring portfolios within asset allocation policies.
“In this type of environment, it can be challenging to discern how the market will react to different fixed-income securities when you bring them to market.”
— Grant Johnsey
Head of Transition Management for North America, Northern Trust
“The value of assets that we transitioned last year increased by more than 30% over 2007, despite declining asset values around the world,” says Grant Johnsey, head of transition management for North America at Northern Trust. “The first quarter of 2009 was busy for us, and activity has picked up sharply in June as we head into the second half of the year.”
Current market conditions have added new layers of complexity to almost all trades, but negotiating the fixed-income market has always been a challenging proposition for investors. Perhaps the greatest challenge is the immense size and scope of the bond market. There are literally hundreds of thousands of tradable bond issues, versus a much smaller universe of stocks. Another layer of complexity exists because there is no central market for bonds like there is for stocks. “Fixed-income securities trade over the counter and many bonds might only be traded every few weeks,” Johnsey notes. “This lack of daily pricing information means investors are largely left to handle price discovery on their own.”
Another issue is that most institutional investors have less interest in purchasing a small position of a bond, known as an “odd lot.” Institutional buyers tend to look for bonds that can be purchased in sufficient size to constitute a meaningful position in the portfolios they manage. Their best prices are typically reserved for sales of at least $2 million to $5 million, which puts odd lot positions at a disadvantage.
Adding to all of these issues, the last year-and-a-half has been marked by drastic changes in investor sentiment and outlook, and thus significant volatility in the bond market. “There have been weeks when certain types of bonds have been very sought after and other times when investors have shied away because they were viewed as too risky,” notes Johnsey. “In this type of environment, it can be challenging to discern how the market will react to different fixed-income securities when you bring them to market.”
A transition manager offers help in overcoming these and other challenges when restructuring a bond portfolio. A good transition manager can help investors unwind portfolios or rebalance by seeking to reduce the risks inherent in the transition, minimizing the cost of trades and helping to coordinate all of the operational and trading logistics.
An experienced transition manager also has the foresight and know-how to plan for risks that might emerge in the market.
From the start, a transition manager seeks to understand the institutional investor’s restructuring goals and then establish a timeline and action plan. Along the way, transition managers should offer quantitative guidance on risks and costs, and continually adapt to client requests, fluctuating market conditions and changes in the portfolio.
An experienced transition manager also has the foresight and know-how to plan for risks that might emerge in the market. For example, a transition manager can devise solutions to minimize the risk that markets could move 5% in either direction at the time of purchase. “Our focus is really on building strategies to manage risk during a volatile time period,” Johnsey says.
Ideally, transition managers also have the industry knowledge and connections to find bids for their clients’ bonds, especially when dealing with an odd lot. Often times, it’s a matter of knowing where to look, knowing who to call and leveraging those relationships.
In the case of a bond that is selling at a deep discount, transition managers can study the fundamentals to see if they are stabilizing or are continuing to deteriorate. “Just because the price of an asset has declined significantly doesn’t mean it can’t decline further. Theoretically they could fall to zero,” Johnsey notes.
“In the past, a fixed-income portfolio that could have been liquidated in a matter of days might take months in this environment while we work the bonds to find the best price,” Johnsey says. “And because the market’s taste for bonds fluctuates wildly, it is sometimes necessary to be patient until a particular bond — or sometimes an entire class of bonds — comes back in favor to avoid a fire sale.”
Once a trade has been completed, transition managers and their clients need to get together and compare initial estimates to real-world costs. This post-trade analysis is an important evaluation tool for institutional investors and a way to gauge the success of a trade.
“Transitioning a portfolio, whether due to rebalancing needs or because of a change in investment managers, can be difficult when so much is uncertain,” Johnsey adds. “A transition manager can provide the experience, the insight and the due diligence necessary to navigate today’s bond market.”