Fixed income portfolio managers are regularly faced with the challenge of allocating new bond issues across clients’ accounts. Incorporating clients’ portfolio targets, investment policy statements, available cash, and other important criteria can be time-consuming and error-prone, and final allotments should be not only fair but optimal. However, automation can be a game-changer with this task. First, to provide a backdrop we take a quick look at the new issue environment in the corporate and municipal bond markets.
Corporate issuance is strong; muni issuance less so
Through the first quarter of 2021, a total of $596 billion in new corporate bonds came to market, an 84.5% increase over the fourth quarter of 2020, and a 5.2% increase year-over-year. Corporations continued to take advantage of low interest rates and some accelerated new issuance with the expectation that rates are likely to be higher going forward. Roughly 2/3rds of new corporate issuance during Q1 2021 was investment grade, 25% was high yield, and private placements made up the balance. Not surprisingly, financials represented over 38% of corporate issuance in the first quarter, with both energy and technology issues comprising approximately 11% each. Both IG and HY spreads fell to multi-year lows in Q1 2021, boosting the appeal of issuing new debt for borrowers across the spectrum. Interestingly, the average maturity of the new corporate issues was 15.5 years, compared to an average of over 17 years in each of the past three years, perhaps reflecting investors’ preferences to rein in duration risk.
In the muni market, total issuance of $104 billion in Q1 was an 8.8% increase year-over-year, but 20% lower than in Q4 2020. The impact of the COVID-19 pandemic on state and local governments has not been as severe as originally anticipated (although many have been strained as revenues from a wide range of sources dried up), and the federal government stimulus package that passed in March of 2021 included a total of $350 billion for state and local governments. As a result, many market observers expect muni issuance to slow, as borrowers may not need as much as previously expected to fund projects. Indeed, in Q1 the supply of tax-exempt munis was slightly below the amount of calls and maturities. Of course, big unknowns include the outlook for infrastructure spending, and the potential for an increase in personal tax rates, which would increase investor demand.
Allocating new fixed income issues across accounts is a perennial challenge
Regardless of whether expectations for new issuance are high or low, allocating bonds across portfolios is always challenging. Two important questions to answer are “where?” and “how much?”
- Identifying which portfolios to allocate a new trade: Portfolio managers have to determine which portfolios are candidates for holding a new issue. The bond’s characteristics in terms of its rating, coupon, maturity, and issuer may be appealing, but it will only be a “fit” for some portfolios, depending upon targets and investment policy restrictions with respect to duration, sector diversification, credit ratings, issuer concentration and so on. Since it is not ideal to seek an allotment of a new issue without knowing that your portfolios have the capacity to absorb it, many IMTC clients use the new issue’s characteristics in advance, to see where it fits.
This is easier said than done, particularly when there are more than a handful of portfolios to consider. Manually checking investment targets and policy statements, verifying the amount of cash in each portfolio, and doing pre- and post-trade calculations to see how much a new issue would move the portfolio toward its targeted structure can be extremely time-consuming. Given the time pressure involved — if you see an offering you like, you have to act quickly — mistakes are not uncommon. Automating the process using IMTC’s Portfolio Allocation tool allows managers to confidently determine which portfolios could absorb the new issue based on each one’s specific targets, either stand-alone or relative to a benchmark, and policy constraints.
- Determining how much to allocate in each portfolio: After you have determined which portfolios are good candidates to hold a new issue, you have to allocate the total amount you were allotted. Fairness is important here, but achieving an optimal outcome across accounts also matters. While making pro-rata allocations (based on the actual total allotment as a percentage of the amount requested) is fair, it is not necessarily optimal. The pro-rata approach may cause some portfolios to end up holding very small lots, which does not make sense from a liquidity perspective.
Often, a better approach is to use a waterfall logic, which the IMTC allocation tool constructs on-the-fly. This allocates new issues according to each eligible portfolio’s relative need, based on criteria that you define. For example, need might be determined by the portfolio’s distance from its duration, targeted sector weightings, or credit quality. For munis, need could be based on the benefit the portfolio would derive from holding bonds from specific states. Or, you could choose to give the highest priority to portfolios that have held the most cash for the longest period of time. For secondary market issues, the IMTC allocation tool also allows you to give preference to portfolios that already hold some of the issue, as doing so would improve the liquidity of the overall position.
Allocation automation = timeliness + accuracy + transparency
Clients have expressed that using IMTC’s allocation tool makes their process 5-6x faster than when they handled it manually and improves their confidence in the outcome. When the allocation process is handled manually, not only is it time-consuming, it can also be error-prone or rely on gut assumptions. Portfolios may end up moving away from, rather than closer to their targets, and there may even be investment policy violations that are costly and embarrassing to reverse.
It also has tremendous benefits with respect to IPS audits, reducing the time involved by as much as 80%. IMTC’s allocation tool allows your portfolio managers and your compliance team to clearly understand what each portfolio would look like after a trade, and creates an audit trail to demonstrate that a trade is in compliance with target objectives and investment policy statements.
In summary, IMTC’s allocation tool helps portfolio managers to:
- Quickly identify portfolios that would be a good fit for a new issue
- Visualize the pre- and post-trade impact of a potential trade against target objectives and policy restrictions
- Objectively allocate a final allotment across portfolios based on chosen criteria
- Spend less time on, and have more confidence in the allocation process
- Put ideas to work faster when used in conjunction with other decision support tools to determine best fit trades across accounts
All of these benefits give portfolio managers more time to analyze bonds and portfolios, better serve clients, and scale up the firm’s ability to handle more accounts.
Technology is only as good as how it is used. IMTC is designed by and for fixed income professionals, empowering them to take action and make decisions quickly and accurately with real-time data and analytics capabilities. It allows you to future-proof your business; driving operational efficiencies, mitigating risk and delivering performance, to ultimately enable business growth. Learn more about IMTC.