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Earning their fees

19 June 2015
Richard Kemmish

With all of the volatility out there, the new issue premium on bonds is coming under increasing scrutiny. One article I read recently suggested – only slightly facetiously – that with the uncertainty perhaps syndicate desks are finally earning their fees. I’m not sure that is entirely true for several reasons.

Firstly, (I could make myself very unpopular here) despite what every syndicate manager will tell you, they don’t earn the fees. The fees paid to an investment bank by a bond issuer are for a variety of services, DCM, advice, sales, secondary market trading, a myriad of other services provided and, yes, the services of the syndicate desk.

To deconstruct that last one: the syndicate desk gets paid to manage the process (mainly shouting at the sales force), to estimate fair value and to advise on an appropriate new issue premium. If they get the fair value right, do they even need a new issue premium?

I’ve always thought that the components of a new issue premium are, an incentive to investors to switch, an insurance against spread volatility before pricing and insurance against the syndicate desk getting the fair value estimate wrong. With investors so desparately short of inventory, the first of these can hardly be relevant. Investors will buy the bonds because they are long cash, not on a switch.

Although rates volatility is high, spread volatility isn’t and covered bond books are never built on the basis of the volatile yield but the stable spread to the volatile yield. Recognising that not knowing a number and the number being volatile are very different things, the second component of the new issue premium seems pretty unimportant too.

Even if there were spread volatility the syndicate desk would very rarely be economically exposed to it. How often – in the covered bond market at least - is a syndicate desk actually long a material number of bonds at the launch of the trade? ‘Underwriting’ (definition: taking on the price risk of the securities that they are distributing) a covered bond is nothing of the sort in the current market.  Some of the most creative speeches I have ever heard have been syndicate desks explaining that the issuer had to widen the spread rather than give the bonds to the underwriter at the spread that they had, er, underwritten them at.

Syndicate desk credibility and economic exposure are very different things.

Which leaves us with the real reason for a new issue premium: we don’t know the fair value of the bonds. Understandable in an opaque and illiquid market. But if the syndicate desk, in the investment bank with the best access to trading data, doesn’t know fair value, what chance does the investor have?

And no, ‘fair value’ is not the same as ‘clearing price’, (take a look at United States Vs Cartwright if you are into that sort of thing). And clearing price can easily be found by auction, with no fees to the syndicate desks at all.

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