Fixed-income markets are growing more efficient by the day, and with this, the old guard of bond fund managers is under pressure. Former stars at established firms are fading — in some cases fast — as market data grow wider, deeper, and into unfamiliar territory. With methods of analysis increasingly driven by computers, firms using systematic approaches to invest are now standing out thanks to how they make decisions based on data.
The harsh reality is that bond markets are changing due to an explosion of available market information. For asset managers who thrived in the opaque markets of the past, the takeaway is clear: Adapt or fade away. We are witnessing a major transformation in fixed-income markets that is driven by data and will level what has historically been an uneven playing field for investors.
For people in other parts of the market, it may be hard to believe that, until recently, buying a bond still involved calling a broker who gave you a price quote over the phone. Prices were based on a range of factors, from sentiment to the broker's inventory, and they did not always align with what was available elsewhere in the market. What you got was a "one-way" quote that prevented you from knowing your real transaction cost.
For example, if you were buying, you knew the broker's selling price, but not where they were willing to buy. Spreads between bids and offers on less-liquid bonds could be wider than half a percent of their total value. When compared to a one-cent spread on a $20.00 stock, this pricing convention for bonds was a massive source of friction, and no centralized exchange made prices for other transactions available.
Without transparency, who you knew sometimes mattered more than an investor's acumen or analysis. Unsurprisingly, this led to bond markets often being dominated by an "old boys club" of traders who executed at the best prices and artificially maintained their information edge.
This was the status quo until recent disruptions started to bring the bond market out of the shadows and into the digital age.
New Regulatory Requirements
The financial crisis of 2008 yielded fresh regulatory requirements for record keeping, pricing and execution that expanded the information available to investors. Since then, additional reporting requirements also increased the types of data available to help investors make decisions. These developments have created a reservoir of new information that firms employing systematic, computer-driven approaches are best-positioned to utilize.
(More: Bond mark-up transparency rule could help investors, cause more work for brokers)
The Rise of Electronic Trading
Following a similar path to stock and currency markets, the number of U.S. investment-grade bonds traded electronically has nearly doubled over the past decade. The electronification of fixed-income trading is making price discovery available outside of traditional voice broker networks that failed to treat customers evenhandedly. As over-the-phone transactions become less efficient for brokers, execution advantages are growing through direct connections and APIs that make dial-up pricing a thing of the past.
Cost-Effective, Transformative Technology
Like other industries ranging from health care to travel, the true equalizer for investing is technology. Modern algorithmic techniques based on factors, pattern recognition and machine learning can now be applied in fixed-income markets. At the same time, cloud computing — through platforms like Amazon Web Services and Microsoft Azure — has dramatically expanded access to computing power that once was only available to the largest institutions. Approaches rooted in artificial intelligence are making it possible for systematic investment firms to analyze data more efficiently and effectively than any human.
As bond markets enter a new age with rapidly expanding data sets, digital execution and modern methods of analysis, the old ways of managing money will die hard. The advantage is shifting to those who process data systematically through the power of computing.
In the next generation of fixed-income investing, winners will not be determined by who you know, but how you separate signal from noise.
(More: The sad but important truth about taxable bonds and AUM)
Andrew Dassori is chief investment officer of Wavelength Capital Management.
