Hedge Fund Bond Price Investigation Focuses on Thinly-Traded Bonds

Multiple sell-side hedge funds are being investigated by the Justice Department for misrepresenting thinly-traded bond prices to falsely boost returns and inflate their fees, according to news sources.

This market is “ripe for abuse,” according to Bloomberg reporter Matt Robinson. US Justice Department and SEC investigators had previously looked at similar abuses at equity funds and are now concentrating on bond funds where pricing is more opaque and difficult to value. The securitized bond debt markets, especially distressed bonds pools, rarely trade, so their pricing is more difficult to verify. This has made it difficult for prosecutors to get evidence or an independent quote to verify their claims that bond prices were falsely inflated.

While investigators continue to advance their cases, vendors are addressing the problem of thinly-traded bonds that has raised issues for both traders and compliance officers. According to a 2Q 2014 study using Federal Reserve data, only 1.8% of all bonds traded on a given day in that period, which marked a 45% decrease from the 2004 tally, according to Golden Source.

Illiquid bond trading has serious ramifications, especially in determining accurate net asset value (NAV) for funds. When prices are wrong, they affect purchase and redemption transactions, inaccurate fund performance statements that damage the reputations of fund companies.

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A July 2016 study (“Best Execution in Fixed Income”) by the Tabb Group found that when dealer quote data decreases, it makes it more difficult to determine a bond’s best price. When this occurs, the price discovery shifts to pre-trade and real-time price modeling. Pricing becomes even more problematic because the study found that “bond trading is concentrated in a very small subset of highly-liquid issues. This means that the vast majority of issues (with unique CUSIPs) do not even trade on a daily basis, creating a major challenge to best execution and pricing analytics.”

To help correct this, Bloomberg launched its BVal evaluated bond pricing product in late-2008. Today, BVal covers 2.5 million fixed income securities worldwide, including international, Euro, local, agency, munis, Treasury and emerging market bonds, including a bond pricing evaluation service to determine prices, especially in illiquid distressed securities.

According to Varun Pawar, global head of the Bloomberg Evaluated Pricing Service, these valuations use a transparent, three-step process that looks at variables, such as issuers and cash flows, and then calculates the spreads and prices to detect any “robust pricing” to help fix a bond’s price.

The actual price evaluation uses a two-step process that relies on data points based on past prices (validated bids and offers) and spreads. For illiquid securities, BVal looks at risk and cash flows to derive a yield based on a comparable bond.

“It is really, really important to have transparency for comparable bonds,” Pawar said.To derive an evaluated price, Varun says, BVAL’s models use available trades along with contributed dealer marks and other bond characteristics. This “triangulation” of available data produces a price that investment managers can rely on when they calculate the fund’s NAV. “In the illiquid space, it is very, very important to know how the relative value pricing model works and what comparable bonds are used to derive the price of the target illiquid security,” he said.

Tags: Bonds, Hedge Funds, SEC

Private equity trends—in particular, demand for private emerging market (EM) opportunities—was among the buzz at the International Finance Corporation’s Global Private Equity Conference, held in Washington, D.C., on May 16 and 17.

Limited partners discussed their appetite for the asset class at a panel discussion, represented by the following asset owners:

Rashad Kaldany, Caisse de dépôt et placement du Québec (CDPQ)
Frank Morgan, Coller Capital
Hideya Sadanaga, Japan Post Bank
Abdiel Santiago, Sovereign Wealth Fund of the Republic of Panama

Josh Lerner, a professor at the Harvard Business School, moderated the discussion.

“Over the last few years, we decided we wanted to do more in all of the alternatives,” Kaldany said, in part due to macroeconomic factors such as low interest rates. The approximate CAD270 billion fund has nearly 27% of its assets invested in alternatives, split among real estate (15%), infrastructure (3%), and private equity (9%). The firm is now targeting a 40% allocation to alternatives, and will gradually lower its listed equity allocations given the high valuations in the public space.

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Regarding the firm’s interest in EM more broadly, CDPQ currently has about a 10% exposure to EM with a target of 13% in the next few years. Kaldany is bullish on private equity EM opportunities more specifically, given the right manager selection. His team ran an analysis on the top-performing general partners (GPs) within developed and emerging economies.

“The top performing quartile managers, GPs, had about almost 2% higher [return] than the top quartile [of GPs] in the developed markets,” said Kaldany. “That’s pretty compelling.” The fund uses the 2% proxy to determine if it should invest in a private equity EM investment relative to a developed market private equity opportunity.

Similarly, the $2 trillion Japan Post Bank is searching for the right partners within private equity EM as well. The bank only began to allocate to private equity in April 2016 and received approval to invest in EM explicitly towards the end of last year. “We think it’s a very important sector we need to pursue, said Sadanaga. “But we need to be careful. We invest mostly through third-party gatekeepers or fund of funds.”

Meanwhile, the $1.4 billion Sovereign Wealth Fund of the Republic of Panama is in the process of formalizing its alternatives strategy. The fund is contemplating allocating between 5-10% of its total assets to the sector. While private equity is accretive to portfolios, there are challenges within the space, according to Santiago. The unconventional global monetary policy and increased competition within the asset class, generally, were among the barriers cited.

Further, the increasing amount of dry powder waiting to be deployed in the sector is creating some angst. “What scares me is the amount of capital available,” said Morgan. In January, about $1.4 trillion of capital had been raised but not yet allocated within private equity. It would take about 4.4 years to commit all of these funds based upon total deal flow in 2016, Morgan estimated.

The need and/or desire to put capital to work may inadvertently pressure managers to execute deals “whether for good or not so good,” added Lerner.

Going forward, CDPQ is focused on more direct and co-investments. While about 50% of its private equity allocation is through funds, the goal is to lower this to nearly 30%. By reducing its role as a limited partner and increasing its role as a GP, the fund anticipates greater engagement within the investment process. “We try to bring in more than just our funds,” Kaldany said. “We serve on the board. We try to be actively engaged.” The fund plans to scale its investments within EM private equity and will concentrate its allocations among a few select GPs.

Sadanaga also remains positive on EM private equity prospects given the GDP growth story within emerging economies. “How [economic growth] translates into investments is another story, so we need to chose wisely,” he said. Given returns on EM private equity have been down, in part because of currency risk, is partly why Sadanaga is currently considering EM private equity investments. Stronger economic growth should translate to the local currency. “Even though you can’t time the market, now is a good time to go in,” he said.

Tags: CDPQ, International Finance Corporation’s Global Private Equity Conference, Private Equity