The results of Greenwich Associates 2006 European Fixed-Income Investors Study suggest that, as Europe’s fixed-income dealers devote more resources and attention to hedge fund clients, traditional long-only fund managers’ risk losing out on research, liquidity and other valuable sell-side services.
Many of the institutions participating in Greenwich Associates’ 2006 research expressed uneasiness about what they perceive to be a troubling situation. European institutions are under considerable pressure to generate robust investment returns to keep pace with mounting pension liabilities or other business demands. However, mark-to-market accounting rules and other regulatory issues are providing new incentives for institutions to maintain relatively high allocations to fixed income, as opposed to higher yielding but more volatile equities. At the same time, the flat yield curve and the relatively low interest-rate environment have made it tough to make money in fixed income.
As a result of these pressures, institutions are being prompted to move into structured fixed-income products, high yield, emerging markets or other asset classes that promise greater returns, and of course, greater risks.
In particular, the institutions interviewed by Greenwich Associates this year voiced concerns about credit risk, the potential for credit defaults and the delivery, settlement and other risks associated with the booming credit derivatives business.
Although hedge funds are not quite the powerful force in Europe that they have become in the United States, they nevertheless represent a significant presence in European fixed-income markets. Hedge fund trading volume in cash bonds and derivatives more than doubled from 2005 to 2006.
While fixed-income dealers would gladly lavish attention on hedge funds on the basis of sheer trading volume alone, there is another reason that hedge funds are so appealing to the sell-side: they are less price sensitive than fund managers, many of which feel a fiduciary responsibility to rigorously enforce best execution rules.
“Despite some suggestions, regulators must ensure that they do not draw too narrowly the definition of what constitutes best execution in fixed income,” says Peter D’Amario, a consultant at Greenwich Associates. “In light of this ambiguity, we advise European institutions not to hamstring themselves by adopting and enforcing an overly narrow definition of best execution. In fixed income and equities as well, best execution encompasses much more than price.”
Overall European fixed-income trading volume, including cash bonds and derivatives, increased approximately 8 percent from 2005 to 2006. Almost all of last year’s growth can be attributed to dramatic increases in trading volume in credit derivatives and a 40 percent jump in agency security trading volumes.
“Credit derivatives trading volume among European institutions nearly doubled from 2005 to 2006,” adds Giovanni Carriere, a consultant at Greenwich Associates. “At the same time, trading volumes in cash credit bonds were essentially flat.”