Institutional investors are using their clout to improve pricing and trading information available on derivative products in the secondary market.
For years, investors have groused that firms were not adequately supporting their products, but it wasn't until this September that the issue came to a head. David Johnson, a portfolio manager at Van Kampen Merritt, gave the market a jolt when he sent a letter to 12 leading underwriters of derivatives saying that he would stop buying derivatives.
Johnson's message has gotten through. The Public Securities Association will soon make recommendations to address the disclosure issue for some primary market derivative products.
In his letter, Johnson said he would stop buying derivatives because some firms were not adequately supporting their products in the secondary market and were not providing details of the products to allow others to make bids. Johnson had been a leading buyer of derivatives and had worked hand in hand with Wall Streets firms to create new structures.
Johnson and other portfolio managers who shared his concerns argued that while the market had worked well so far, the disclosure and other secondary market concerns could hurt the liquidity of derivatives in a down market.
Within weeks of the Johnson letter, the Public Securities Association formed a task force includes representatives from many of the leading firms in the municipal derivatives market, and also from Muller Data Corp., Bloomberg LP, and Kenny Information Systems.
The task force has not yet released its proposal, but is expected to do so soon.
One idea the PSA is considering is drawing up a list of features that underwriters should release to buyers and to the information services. Industry standards may include a worksheet for each product that lists the information that firms should provide.
The PSA could also go a step further and recommend that underwriters "standard" their products around identical structures. But with firms fighting to woo issuers and investors, standardized products would make it more difficult for the firms to differentiate themselves.
Derivatives products have a host of speical features that potential buyers need to know about, including the index that a product is based on, how interest is calculated, the coupon on the underlying bond, the call features, the ratings, the Cusip number, and other basic facts. Buyers of swap-based products also need to know the swap counterparty.
Without the specific details, buyers are generally unwilling to make bids on a derivative. One portfolio manager said he had to fax a firm details of a derivative he wanted to sell before the firm would make a bid.
The task force could recommend that firms immediately begin broadcasting information on new deal, but old deals are a knottier issue. The task force could ask firms to supply the information on old deals, but that could take time.
But the PSA is not conducting a study of existing disclosure standards. The task force is looking forward.
"It's our feeling that up until this point, the market has functioned relatively well," said Michael G. Rantz, a partner at Goldman, Sachs & Co. and a co-chairman of the PSA task force.
"These instruments have provided investors with the sorts of price performance characteristics that they wanted to see. As the market grows, we have to continue to evolve and grow with it, and that's what this process is all about."
Because the PSA is an industry group, and not a governmental body, any standards will be voluntary. But task force members said they expect broad compliance because they are seeking input on the standards from officials at firms not represented on the task force.
"We really expect all dealers will follow the guidelines," said Rantz, the co-chairman. "I don't think investors want to do buisness with a firm that isn't willing to make that information available."
One derivatives professional not on the task force said that a trading difference would develop between similar derivatives if full information was available about one and not the other.
"Once you put this info out there, people will demand it. I think only a few buyers will be willing to buy without that," the professional said. "And if you don't [provide the information], there are fewer buyers and that means less demand and less liquidity."
Keeping Pace With Change
For now, the task force is not planning to release standards for derivatives created in the secondary market. But the task force will consider expanding the standards in the future to cover secondary market products or new primary market structures.
"As the market evolves and becomes more diverse, we may have to come up with a more general approach," Rantz said.
Until now, portfolio managers and some market participants say, change has been slow to take hold in the derivatives market.
"So far nothing's happened," said David MacEwen, a senior portfolio manager at Benham Capital Management whp primarily purchases inverse floaters.
"But some of th dealers look as if they're trying to make a better market."
Since the Van Kampen letter, MacEwen said that some underwriters such as Lehman Brothers, Goldman Sachs, and Merrill Lynch & Co. appear to be more actively trading derivatives.
The Benham portfolio manager believes pricing information on derivatives for resale in the secondary market remains inadequate, with some securities offered at prices higher than those at which they could be resold.
In addition, dealers still produce "the best bids on their products because they don't have the information on the other products," MacEwen said.
There also is need for a more standardized derivative, such as "a cookie-cutter inverse floater, so you don't have to worry about the nuances of each deal," he said.
Currently, features such as interest rate reset periods, call provisions, methods of interest calculation, and linkage options can vary. This means that to sell a security, an investor must often search out bond documents or call the firm that underwrote the securities, MacEwen said.
The lack of standardization "is a factor in the liquidity problem," said Paul Disdier, a vice president at Dreyfus Municipal Bond Funds in New York.
"I don't think there's been any real change," said Thomas J. Kenny, director of municipal research at Franklin Advisors in San Mateo, Calif.
"They're so busy dreaming up their next conceptual product that they're too busy to think about the [existing] product."
Franklin Advisors follows developments in the derivatives market, but does not purchase the securities, Kenny said.
The firm, one of the largest in the tax-exempt mutual fund arena, shuns the products for several reasons, he said.
First, derivatives do not fit Franklin's investment objectives of providing high current income and preserving principal.
Second, the firm is concerned that derivatives may be volatile securities that have not been tested in a bar market.
Third, Franklin does not feel there is enough liquidity in the market, and that secondary pricing information is inadequate.
Franklin also has questions about the tax-exempt status of some derivatives manufactured in the secondary market, Kenny said.
However, the firm does favor increased disclosure on derivatives.
"If it means better disclosure, we would support any product whether it's a derivative or not," Kenny said.
Clark D. Wagner, chief investment officer for First Investors in New York, said, "I think things are improving somewhat" but "there is more need for better secondary market disclosure."
Wagner said he believes there is more information available now on the derivatives developed by various underwriters than there was six months ago. However, he said he found it difficult to judge whether there has been improvement in the market because he has done little trading of his derivatives in the past few months.
Although Wagner and many other buyers have purchased derivatives as long-term holdings, the porfolio manager said he will favors increased liquidity for the products.
Increased liquidity would enable portfolio managers to unwind derivatives positions at a lower marginal costs, Wagner said.
However, "it's unrealistic to believe these things will trade like dollar bonds."
In addition to increased liquidity, Wagner also favors more homogenous derivative products, which would enable more uniform pricing and involve more dealers in trading the securities.
"I think the market is moving in that direction," Wagner said.
Uniform pricing information on derivatives, perhaps along the lines of the PSA's proposal, would enable more dealers to bid on different products, Wagner said.
One problem is that at each firm, few traders than investment bankers are knowledgable about the securities.
"Usually there's one person at each firm who knows how the product should be priced -- and that's part of the problem," Wagner said.
When that one person is unavailable, it is difficult to trade the securities, he said.
Due, however, to the limited amount of secondary trading of derivatives, few firms may have enough incentive to increase the number of traders who know about the securities, Wagner said.