The Aleph Blog » Blog Archive » The Education of a Corporate Bond Manager, Part III

The Education of a Corporate Bond Manager, Part III

A reader MorallyBankrupt, asked,

What I am wondering here is the following, how fast was the decision process? For those of us that have never worked in the new-issue market for corps, the timeline is not obvious. How did it all flow, from getting notice of the deal, to getting a feel for the demand for it, to knowing what the offering price was going to be? How long did you have before requesting allocation in the deal?

Good question.  I answered part of this in the last piece.  It would vary based on three things:

  • The complexity of the deal — more complexity, more time
  • The creditworthiness of the issuer — lower creditworthiness, more time
  • The speculative nature of the market — less speculative, more time

Most new issue corporates do not require explanation; they are just straight bond deals.  Senior unsecured, do the credit work, do you want into the deal or not?  But some deals require thought.  When Prudential (US) went public, they securitized the business associated with their oldest policies, and issued debt against it.  Thick prospectus.  Many scared away in the midst of the credit troubles in 2002.  I looked at it and said, “They are offering more yield than on their surplus notes, but with better protection.  Time to buy.”

So I called my broker at Goldman and expressed interest in the deal.  He sounded a little surprised, and said that few had offered orders yet.  I said that I was interested, and he said that the syndicate would be interested in pricing guidance.  I gave him a schedule where I would be willing to buy more as the pricing went higher in spread.

But after that, I asked for protection on my order.  Early orders deserve protection.  Protection means you will get everything that you asked for, while others get pro-rated if the deal is successful.  They protected my order, which was large for us, while the marketing of the deal continued.

As it was, in the midst of the chaos of 2002. there were few takers for the low risks in a complex deal like that of Prudential’s old business.  So as the deal came to pricing, the yield rose.  The eventual yield for the non-guaranteed bonds was 8.695%, yielding a price in the $98s.  The first trade was $104, and went up from there.  What could be better  for us?  I bought some more when my credit limit expanded at $108.  What a great misunderstood bond.

But that is the way things work when credit markets are slow.  When they are fast, deals close rapidly, and syndicates allocate bonds proportionately to where their estimate of buying power is.  There is no protection there, aside from any big investors who move very early.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==-=-=-

But now onto the times when markets go nuts.  Deals are closing in less than 10 minutes.  You have to get your order in rapidly, or you will get nothing.  My one minute drill helps, but is not perfect.  On a deal on Disney bonds, they had a great yield in a hot market.  I bid for $30 million in bonds, and found myself trapped with 30 million of Disney long bonds, after an allocation that went bad.  I flipped 10 million for a small gain, and another 10 million at par, leaving me with 10 million that I did not want to hold.  I waited, and took my losses later.

But more often, I would avoid the deals when they got hot, and let others buy them.  I had strong opinions on what would work and what would not.  I remember several large deals where the syndicates begged me to buy (GE Capital, and AT&TWireless) and I refused.  The speculative cycle was high, and it was fun to refuse Wall Street when it was trying to stuff accounts full of promises that were underpriced.  I did not play in those deals, and it was fun to see the deals fail, and prices fall considerably versus the original offer.

In order to keep the system honest, some deals had to fail, and not provide profits to those who would flip.  Otherwise, many managers would beg for more bonds than they could hold onto, just so they could flip them.  When the market runs hot, the odds rise that the syndicates will overprice a deal, to deliver losses to those that foolishly ask for overly large allocations.

=-=-=-=-=-=-====—-=—==================

Once you had notice of a bond deal, you could act. You could put in for bonds if you wanted.  But when conditions were speculative you had to move rapidly, and ask for an allocation quickly, or risk getting nothing at all.  Once the books closed, that was it.  Also, if multiple dealers controlled the books, it paid to put in through all of them.  One might have influence that the others did not on very rare occasions.  You wanted all of the bookrunners fighting for you.

All of that said, on some deals you would end up with a lousy allocation, and get less than 10% of what you asked for.  At times like that, one would typically flip the bonds to the highest bidder, because it was not worth the bother to hang onto a small position.  On massively oversubscribed deals, the percentage profits on the flip were high, but they weren’t big in dollar terms.

As an aside, occasionally, shortlyafter the deal closed, if you had a sterling reputation, and could say to your brokers that you had been hindered from putting in for bonds but had wanted to, you could still squeeze in.  Reputation and size matters.

Some deals were highly subscribed by large sponsoring buyers before deals went public.  Those deals would open and close in a minute shutting everyone else out but the large buyers, and what few got some crumbs.  I remember getting crumbs on a few occasions.

One way you could get the syndicates to notice you, was that if you really liked a deal, you would buy on the break.  The break is where bonds become free to trade.  Now, truth, there is what is called the “grey market” where after bonds are allocated but before they are “free to trade,” you could deal them away, or, buy some more.  Dealing in the grey market has some taint, and you don’t want to be seen doing it, lest your allocations be reduced.  The opposite is true for those who buy through a syndicate dealer on the break.  It shows the syndicate that you are a real money buyer, as opposed to  a flipper.  Syndicates want to place bonds entirely with long term holders if they can; that is their goal, because it means they priced it right, leaving little money for mere speculators.

As for me, I employed one second tier broker who would buy lousy allocations from me on oversubscribed deals.  No reason to make the analyst write it up.  It wasn’t worth holding onto, and the yield after the break was not attractive enough to buy more.

More to come in part 4.






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3 Responses to The Education of a Corporate Bond Manager, Part III

  1. Greg says:

    David -

    A while back (I can’t find the exact post), you said investors should prefer corporate bonds over stocks if the BBB yield was at least 3.9% higher than the earnings yield (E/P)

    Lately, the “E” in E/P has become a work of fiction writing for many companies. More importantly, the “E” is just an accounting entry – subject to a lot of FASB vagueness and subjective interpretations.

    I prefer to look at real cashflows, because those are much more difficult to fudge, at least on a long term basis

    If I look at dividends paid (which unlike eps are real money) — what sort of yield spread should an investor look for?

    And a related question: if I must look at earnings yield, does the 3.9% spread work when looking at “normalized” earnings? Seems like a 10yr average might be too insensitive / trailing — by the time you saw a 3.9% spread, it would be too late to make a trade

    Thank you in advance for your thoughts

  2. matt says:

    Hello Greg.

    You are looking for the following post:

    http://alephblog.com/2007/07/09/the-fed-model/

    Mr. Merkel specifically mentions your concern:

    “The fourth limitation: a high earnings yield might reflect low earnings quality or profit margins higher than sustainable. No doubt that is possible, and particularly in the current era. On the flip side, there may be times when a low earnings yield might reflect high earnings quality or profit margins lower than sustainable. A rule is a rule, and a model is only a model; they don’t reflect all aspects of reality, they are just tools to guide us.”

  3. Joshua Chance says:

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    Hi David,

    Great series!

    You mention that reputation/size matters. Are there any “poker” aspects of reputation that can be detrimental? For example, if you develop a reputation for consistently making good purchases do brokers catch on and markup prices with the idea that your interest in a bond is evidence of underpricing?

    Josh

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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