Mi­fid II threat­ens bond al­lo­ca­tion mine­field

Reg­u­la­tions de­signed to bring trans­parency to the busi­ness of sell­ing debt in Europe


When a cor­po­rate bond sale draws 10 times as many or­ders from in­vestors as the amount of debt avail­able, how do you de­cide who gets what?

It is an is­sue bond syn­di­cate bankers grap­ple with on a daily ba­sis. But from Jan­uary their de­ci­sions will face much more scru­tiny un­der the EU’s Mi­fid II reg­u­la­tions, sweep­ing new rules that aim to im­prove trans­parency and fair­ness across fi­nan­cial mar­kets.

Un­der Mi­fid II, a banker must pro­vide a jus­ti­fi­ca­tion for the fi­nal al­lo­ca­tion made to each in­vestor in a bond sale. This piece of the reg­u­la­tion tries to ad­dress com­plaints from small in­vestors that banks man­ag­ing bond sales favour the largest as­set man­agers, hand­ing them more debt as a quid pro quo for fees pro­vided from other busi­ness.

But Mi­fid also has rules de­signed to pro­tect re­tail in­vestors that could stop bankers al­lo­cat­ing bonds to the small­est in­vestors en­tirely.

Ruari Ewing, a se­nior di­rec­tor at cap­i­tal mar­kets trade as­so­ci­a­tion ICMA, said these “prod­uct gov­er­nance” rules were “the sin­gle big­gest chal­lenge Mi­fid poses to bond syn­di­ca­tion”.

“The rules are writ­ten for the re­tail struc­ture prod­ucts mar­ket, where they work well, but they are con­cep­tu­ally dif­fi­cult for vanilla bond syn­di­ca­tion,” he said. “The most likely ef­fect is that syn­di­cates will fire­wall most deals from re­tail in­vestors — which is eas­ier said than done.”

The prob­lem is that Mi­fid II re­quires the cre­ation of a three-page in­for­ma­tion doc­u­ment for re­tail in­vestors, sum­maris­ing the risks. But an of­fer­ing mem­o­ran­dum for a cor­po­rate bond usu­ally runs to hun­dreds, and some­times even thou­sands of pages, in an at­tempt to cover all po­ten­tial le­gal li­a­bil­i­ties. Cram- Gen­eral Elec­tric (in­vest­ment-grade cor­po­rate bond)

‘When you have six banks openly dis­cussing al­lo­ca­tion, li­a­bil­ity is split’

ming this into a few pages would be im­pos­si­ble, leav­ing banks open to law­suits if a deal went wrong.

Mean­while, for large in­sti­tu­tional bond buy­ers the ten­sion over the al­lo­ca­tion process has only height­ened as sec­ondary mar­ket liq­uid­ity has dried up. This has made in­vestors in­creas­ingly be­holden to the pri­mary mar­ket to source debt, mean­ing that or­der in­fla­tion — where buy­ers bid for more bonds than they want — has be­come rife.

Syn­di­cate bankers al­ready fol­low strict in­ter­nal guide­lines to nav­i­gate these tricky con­sid­er­a­tions. And banks are in the process of de­vel­op­ing drop­down menu sys­tems and au­to­matic record-keep­ing mech­a­nisms, to help meet the new rules with­out caus­ing ma­jor dis­rup­tion to the con­stant flow of pri­mary bond busi­ness.

But many bankers complain it is very dif­fi­cult to sum­marise de­ci­sions made un­der time pres­sure in a for­mat open to reg­u­la­tory scru­tiny. “I think, un­for­tu­nately, it’s go­ing to be­come more com­modi­tised,” said one cor­po­rate bond banker, ar­gu­ing that most in­vestors will sim­ply get a set al­lo­ca­tion based on what type of fund they work for, rather than their en­gage­ment with the deal process.

The new rules on al­lo­ca­tion could pose the big­gest chal­lenge to Euro­pean high-yield bond sales, which fol­low very dif­fer­ent con­ven­tions to the in­vest­ment-grade cor­po­rate mar­ket.

In Euro­pean in­vest­ment-grade bond syn­di­ca­tions, the bookrun­ners all take or­ders and then col­late them at the end, re­mov­ing any du­pli­cated or­ders in a process called “rec­on­cil­i­a­tion”. They then host an al­lo­ca­tion call to de­bate and de­cide which in­vestor gets what.

But the high-yield mar­ket largely fol­lows a US con­ven­tion whereby a “left­lead” bookrun­ner ef­fec­tively con­trols the deal. “When you have six banks openly dis­cussing al­lo­ca­tion, li­a­bil­ity is split,” said the in­vest­ment-grade bond syn­di­cate head. “But when you have one bank on the left, they’ve got to take full re­spon­si­bil­ity for how the book is al­lo­cated. That’s go­ing to be a very un­com­fort­able po­si­tion to be in.”

High-yield syn­di­cate bankers are also more lib­eral with the zero but­ton — rou­tinely hand­ing in­vestors no bonds what­so­ever. One high-yield bond banker said that some­times up to 40 per cent of the ac­counts in a book can get ze­roed.

Per­haps the big­gest prob­lem with the new reg­u­la­tion is that it fails to recog­nise a fun­da­men­tal fact of the bond mar­ket — that syn­di­cate bankers do not have the fi­nal say on al­lo­ca­tion, the is­suers them­selves do.

“Most trea­sur­ers take a quick look at the fi­nal book and sign off on it,” said the cor­po­rate bond banker. “But some re­ally do get in­volved in the al­lo­ca­tion process. And it is the is­suer’s book at the end of the day.”

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