Author: Rob Arnott, Head of Brokerage, APAC

As global interest rates rose last year, the investment in fixed income rose with them. And even as rate cuts are expected, fixed income continues to offer desirable yields and downside protection amid continued economic challenges.

Institutional investors are taking note: according to a 2024 Northern Trust survey of 300 senior leaders from global asset management firms with assets under management (AUM) of up to US $500bn, for respondents focused on supporting new asset classes in the next two years, nearly 40% of Australian managers plan to increase allocations to fixed income.¹

The Super industry echoes this sentiment. AustralianSuper, Australia’s largest Super fund with $335 billion under management, have approximately $50 billion invested in fixed income as of June 2024, representing 15% of total assets. Whilst this is a decrease from peak investment of 20% in 2023 it is still toward the top of the asset allocation range cited by Katie Dean, head of fixed income, currency and cash at AustrailianSuper, currently citing a range of 5-20%.²

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. Australia’s AUD$3.9 trillion (as of March 2024)³ Super industry has seen larger funds build out internal investment teams and capabilities in an effort reduce costs for members. According to Super Review,  AustralianSuper, along with other mega funds like HESTA and UniSuper, have increased direct investment holdings to approximately 75% as of June 2023.⁴

Whilst this is the case for larger funds that can benefit from scale, this is not the case for smaller managers who still see value in partnering with external managers and service providers. 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 US$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 and 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, but 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. 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 can 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 the Northern Trust survey, when asked what areas they would consider outsourcing, nearly a third said they would outsource their trading function. 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] Driving Growth in Asset Management 2024 | Northern Trust

[2] 'Every day a new day' managing fixed income for AustralianSuper - Investment Magazine

[3] Super Statistics - ASFA The Voice of Superannuation since 1962

[4] Big super leads charge towards investment internalisation | Super Review