Remarks at the Bond Market Association Annual Meeting

Douglas Shulman

Vice Chairman

New York
April 20, 2005

Navigating the Changing Climate in Fixed-Income Products

Good morning.  Thank you for the introduction.  It's great to be here with the professionals that drive this diverse and important market.  Having just spoken here at the Waldorf at the BMA's Legal and Compliance Conference in February, and again at NASD's Fixed Income Conference in March, I'll try to rise to the challenge of not repeating myself.

I expect many of you will agree that these are times of profound change in the fixed-income markets.  Today I'd like to walk through three trends that I see as the principal drivers of this evolution:

  • One, market and demographic trends are reshaping the profiles of bond investors, and that in turn alters the demands placed on all market participants.
  • Two, the tools and resources available to those investors are more plentiful and varied than ever, but they are demanding more still. 
  • And three, everyone's ability to stay ahead and prosper in this environment will depend in part on their proactively managing change rather than being managed by it.

Let's take a look at the shifting investor profile - first from a professional, then from an individual, perspective. 

The professional bond investor, who in most cases acts as a fiduciary, and can be considered a proxy for individual investors, today represents over $1 trillion in assets just in mutual and hedge funds.  Let's consider how this breaks down: there are close to 1,300 taxable fixed income mutual funds representing approximately $974 billion in assets.1 Along with pension funds, these investors form the backbone of traditional managed money.  Historically their charters have focused them on narrow segments of the market.  But as the markets have become more complex and rotations among markets have accelerated, they have begun to modify their charters to give them more freedom to invest in a broader group of products to improve returns for their clients.

Now let's consider the fastest growing group of professional investors on the scene - the hedge funds.  According to Hedge Fund Research, there are over 7,000 hedge funds - nearly a third of them less than two years old.  Although fixed income assets in this sector grew by only $5 billion in the fourth quarter of 2004 - bringing the total to about $77 billion - in percentage terms they grew at more than twice the pace of taxable bond mutual funds.2  As you know, these investors are anything but traditional - they can play across the entire spectrum of fixed income products, use leverage, and actively trade the markets every day.  Their search for yield and untraditional products typically takes them to the high yield sector of the market.  Often, their sophistication and access to information from multiple firms allows them to know as much about the markets and issues as you do.

What do these two classes of professional investors have in common?  Well, by necessity they are very shrewd and sophisticated, and becoming more so, about searching for return - across markets and around the world - and about managing risk.  Increasingly they are looking at multiple markets to find the best investment opportunities.  All are looking at - and, where their charters permit - using, derivative instruments as well as cash products to enhance returns and manage risk. They increasingly see less aggregate capital at risk because of industry consolidation and therefore are absorbing more risk themselves.  This necessitates more sophisticated cross-product models and analytical tools to make the best judgments.  As a result they are demanding the availability of more information and data to drive these models.  In addition, they are increasingly demanding improved operating efficiencies through standardized communications protocols across products and markets, as well as consolidated and more efficient settlement facilities.

Now, let's consider the individual bond investor, whose aspirations aren't so terribly different from those of the professional.  While these people by definition do not account for a lot of bond volume, because they transact in small amounts, they are increasingly becoming an important part of the bond marketplace.  Because they transact in small sizes, they have not brought large profits to trading firms, and their needs, understandably, have traditionally played second fiddle to the institutions.  But, today individual investors are demanding much more attention and their behavior is increasingly affecting everyone in this room.  Why?  Research indicates that in one sector, corporate bonds, about two-and-a-half million American households have direct holdings, that is, outside IRAs or 401(k)s.  These investors represent two-thirds of corporate bond secondary transactions.

The average bond investor is older and more well-heeled than the general investor.  He or she has a mean age of 59 and mean household assets of $1.4 million, of which $900,000 is liquid.  The general investor's mean age is 51, household assets are $343,000, and liquid assets are $148,000.3

Individual investors are getting smarter every day about investing - and the more they learn, the more they want the same information disclosed in the same way from one market to the next.  For example, it's likely that the individual bond-buyer uses the Internet for investing.  About 53 percent of corporate bond-holding households do, compared to 19 percent of households generally.4  And it is likely that he or she wants to be able to use the Internet even more - not just for account information and equity research and trading, but also for fixed income products.

Like the professional investor, the individual investor is growing restless after three or four years of lackluster performance in their equity portfolios.  They're reevaluating their investment strategies and looking around for ways to get consistent returns or more bang for the buck.  Some are seeking advice from professionals and others are actively diversifying their product mix to manage risk and enhance returns.

And these investor demands are anything but static. We are an aging society.  The oldest baby boomers turn 59 this year.  Over the next decade, they'll start retiring in huge numbers.  The United Nations projects that, in the United States, there will be about 34 retirees per 100 working-age people in 2050.  In Europe, there will be 60 retirees for every 100 working-age people, and in Japan, a staggering 78 per 100.  This rapidly growing segment of the developed economies is driving the well-publicized concerns about Social Security and pension viability.  In addition, the aging of industrialized societies should rapidly increase appetites for fixed income products as the need grows for more stable returns to fund cash needs and to protect against inflation.

So investors' needs are changing and the pace of change is accelerating.  What sorts of demands are you likely to face in this dynamic new world order?

I see two principal and related trends.  One is that the universe of markets and products that offer investors at least some fixed-income exposure is growing rapidly.  Today investors can gain fixed income and credit exposure in cash, credit derivative swaps (CDS), futures, REPO, options, and ETFs over several time zones.  The nascent CDS market has grown exponentially over the last few years and almost everyone predicts continued rapid growth.  Although still relatively new, the six major fixed income ETFs had about $10 billion in assets at the end of 2004, double the amount of a year earlier. 5 

How might investors demand access to these various instruments?  Well, professionals, especially leveraged players, are looking to dealers to provide them with cross-market liquidity and access.  This demand is being partially satisfied by prime brokerage operations at bulge-bracket firms that offer services across multiple asset classes.  This demand is also being satisfied by the roughly 40 online electronic platforms, such as TradeWeb, BondDesk, and MarketAxess, where one can trade multiple fixed income products.  Many of these platforms offer consolidated access not only across dealers, but also across instruments - governments, agencies, mortgage-backed, CDS, and commercial paper to name a few.

I spend a fair amount of time visiting trading floors.  I've seen many of you are starting to consolidate your trading and institutional sales operations across markets to improve service to your clients.  Ten years ago, many of you were trading cash products and using futures as a hedge to manage risk. Today, you are trading derivatives and cash products side by side and possibly by the same person.  Some have been trading multiple fixed income markets side by side, and I'd bet a few are even trading issuers across stocks and plain vanilla bonds - all of this in a drive to meet the needs of an increasingly demanding client base.

This drive for consolidated access is also heightening concerns about operating efficiencies and straight-through processing within and across the various markets.  More automated processing is coming to the fixed income markets from the point of sale to settlement and reaching further to the client.  Increasingly, investors are insisting on more automated order management, execution and the resultant standardized communications protocols such as FIX for fixed income to facilitate processing.  Finally, they are looking for increased access to research and analysis.

Again, the challenge we all face is to understand and manage all this change, rather than letting it manage us.

Now let's add another player to the mix - the regulators.  As you have no doubt noticed, we have increased our focus on the fixed income area in recent years.  We have launched TRACE, bringing unprecedented transparency to the corporate bond market.  We have increased the breadth and depth of investigations and enforcement actions in fixed income.  We recently proposed new disclosure rules   And, we have also increased our efforts to support firms compliance in this area, launching tools like our online Report Center to provide compliance statistics and peer group comparisons and hosting conferences on the subject.  The common theme of all of these activities is that more disclosure is better and investors must be given all of the information necessary to make good asset allocation decisions.  If we focus on disclosure, then we believe that market forces will naturally create efficiencies.

As we have increased our focus in this market, we are not simply transferring the disclosure rules of the equities markets to fixed income.  We recognize that there are major differences in the complexity of the instruments, and bond investors have always actively traded across markets to hedge their transactions and manage capital exposure. 
Because of these and lots of other differences, a one-size-fits-all approach to information disclosure would be the wrong way to go.  However, we also can't ignore the lessons of one market when thinking through the needs of others.  As we feel our way through the process of figuring out what kinds of information - and how much of it - investors need, we want to make sure we solicit feedback from knowledgeable industry players.  But wherever we end up, there is one fundamental reality that's not going to change: fixed income transparency is the new standard in our industry.  It's here to stay.

If you've heard me speak in the past couple of years, you've heard me talk about TRACE - NASD's Trade Reporting and Compliance Engine.  This has proven an enormously helpful tool for investors in search of basic trade and price information about corporate bonds.  We have also been told by many traders - albeit begrudgingly - that the data has been helpful to them.  After about three years of incremental growth, TRACE provides information on 29,000 corporate bond issues, and for more than 80 percent of the transactions it makes the trade information publicly available within five minutes of the transaction.  On July 1, we'll narrow the current requirement that members submit transactions within 30 minutes, to 15 minutes.  This will further improve the elapsed time between the trade and public dissemination of it through any of the major data vendors redistributing TRACE or through our BondInfo or the BMA's Investing in Bonds Web sites.

Today we are working very hard to improve the accessibility of TRACE data.  We have assisted the BMA in getting started with real time TRACE data on its Web site.  We are continuing to work with a number of broad-based public financial Internet sites that want to display TRACE data.  We are now displaying market aggregate data on our Web site and in The New York Times and are fielding more and more inquiries regarding how to access this kind of information.  Another area of particular interest to us is market benchmarks to help investors measure their investment performance.   We think individual investors would welcome new, targeted benchmarks and are looking at this closely.  In addition, the number of vendors and member firms who are using the data grew to over 40 in March and represent over 7,000 real-time users.  And we know that many are using the information in new and more sophisticated ways.

As I said, TRACE has been enormously helpful in making the corporate debt market more transparent, but it's only one part of the puzzle.

We're also concerned about the quantity and quality of information presented to bond investors. So we have proposed a requirement that salespeople present retail investors and potential retail investors with a more detailed picture of what they're getting into.  These would apply only to individual, non-institutional buyers.

If filed with, and approved by, the SEC, the new rules would require increased disclosure of basic information about corporate bond transactions in five ways:

  • First, a customer in a debt transaction would have to be clearly and explicitly informed if he or she is paying a commission, mark-up or mark-down.  In the case of mark-ups or mark-downs, the amount of compensation is not required but the fact that there is compensation must be disclosed.  Our research has found that about a third of people who consider themselves investors either think bond transactions are free or don't know whether they are or not.
  • Second, a broker-dealer effecting a bond transaction would have to disclose the bond's rating, if any, from any rating agency to which the broker-dealer subscribes.
  • Third, the broker-dealer would have to disclose whether transaction price information is available for the bond and, if so, where.
  • Fourth, the broker-dealer would be required to inform the customer of certain special features of the bond, such as call provisions and the nature of coupon calculations and payments.
  • And fifth, the broker-dealer would have to refer the customer to a tutorial on the basics of bond investing. 

We proposed these rules to make sure that the individual investors get all the information they need when dealing in corporate bonds, ever mindful of the fact that it's possible to give them more information than they want or need.  We think these proposals strike that balance, but we're certainly open to your comments and suggestions.

I think we would all agree that at the advent of the twenty-first century, when a large and growing proportion of America's households has money invested in bonds, there simply is no good reason for incomplete disclosure in the bond markets.  And while we've said that we won't bring the disclosure regime of equities to the fixed income markets in a wholesale manner, we also have to recognize that investors expect clear information about any product in which they invest.  And the nature of transparency is that once investors see it in one place, they want more of it in others.

There will always be those who resist change and adapt to it only when left with no choice.  A lot of people regarded cell phones as frivolous luxuries when they came into vogue 10 or 12 years ago.  I suspect most of those people now have them and never go anywhere without them.

So it is today with fixed-income markets.  You can dismiss the changes as a passing fad.  Or, you can embrace them and learn how to flourish from them.  Doing so is in your interest not just because it will keep you in the good graces of the regulators.  It is also in your interest in that it's good for your clients and therefore your business.  You are much better off with a confident, well-informed investor than a tentative, ignorant one.  The former is less likely to blame you and drag you into arbitration when things don't turn out the way he had hoped.  Moreover, the confident investor historically has been the active investor, and active investors bring business to your firms.

So, I'll leave you with a few suggestions.  Adapt to this new way of doing business and to the heightened regulatory emphasis on compliance and disclosure.  I can assure you, that emphasis is not temporary.  Don't simply comply with the new rules, but rather infuse your firms with a culture of compliance - a culture in which staying on the right side of our rules and the federal securities laws is at the heart of everything you do.

Adopt the point of view that both you and your customers are better served by their having all the information they need to make informed decisions - information about the risks of a particular investment presented with the same illumination as information about the benefits.  Embrace the information that is available. The more open you are, the more you will build trust with your clients.  And that is a solid foundation for higher volumes and more business.  Then remember - you must leverage this data for your clients' good, if only because your competitors are likely to do it.

Work to ensure that the information you provide is accurate and timely so it can be used effectively in the marketplace.  Remember, you increasingly depend on the information provided by your competitors and therefore have an obligation to ensure that your information is as accurate and timely as theirs.

Do the suitability analysis for individual investors before you make the sales recommendation.  This is very much in your interest.  NASD's Office of Dispute Resolution received more than 7,000 requests for arbitration of disputes between brokers and clients last year, and a sizeable portion of those had to do with suitability - or lack of it.

Adapting your business model to these new realities will not require you to fly without radar. There is today a broad assortment of tools and resources for broker-dealers and investors to stay ahead of the curve - electronic trading platforms, investor education resources and so on.  And NASD is working night and day to provide professionals and investors with as much help and useful information as we can.

Of course, selling securities has always been and will always be characterized by the balancing act of managing risk and return.  If you're looking for consistency, you'll always have that.  But very little else in this business is constant.  If you take these few simple steps I've recommended, you will be well served in this rapidly changing business and regulatory climate.

Thanks again to the BMA for inviting me. And thank you all for listening.  If anyone has questions, I'd be happy to try to answer them.

1 & 5 Mutual fund and ETF data from Investment Company Institute
2 Hedge-fund data source: HFR Industry Reports © HFR, Inc. 2005,
3 & 4 Retail investor profile data from SRIC-BI's MacroMonitor