Importance and Challenges of Accurate Bond Pricing

Scroll down

Recent developments in the global financial landscape have increasingly focused attention on the approach to the valuation of financial assets held by institutions - for their own requirements or that of their customers. There have been a number of high-profile losses and failures that have been directly attributable to the mis-pricing of assets, either fraudulently - with real values being withheld or obscured - or mistakenly due to error or incompetence. This is important because, as regulators and accountants know and acknowledge, the “true” valuation of assets is at the core of the key principles underlying fair reporting and robust risk management. Without accurate valuation, then the whole infrastructure of the regulatory, reporting and risk management system is built on shifting sands. In the case of the bond markets, ‘accurate’ valuation is especially challenging. Unlike the equity markets, only a small percentage of outstanding bond issues actually trade in a meaningful way on a regular basis. This results in a large proportion of the market that is essentially illiquid, requiring estimates of current value to be made. Not only do a large chunk of the bond markets trade irregularly, these transactions typically take place over-the-counter (OTC) and not on exchanges. This leads to an inconsistent and variable landscape for the reporting of these tickets, so even if a trade takes place market participants may not necessarily learn about it in a timely fashion, or, in some cases, at all.

Methods of Bond Pricing

Trades

A recently recorded trade in a bond has traditionally been regarded as the best indication of its current value. This notion is enshrined in much of the regulatory and accounting framework that surrounds portfolio valuation. In addition, given that only a small proportion of the bond markets actually trade on any given day, these ‘real’ prices for liquid issues form the primary inputs for much of the bond pricing methodologies applied to illiquid securities, being used to create benchmark yield curves and credit spreads. With the bond markets trading Over the Counter (OTC) rather than on exchanges, it was historically challenging to discover what trades took place and at what price and volume. This started to change in 2001 when the SEC introduced the Trade Reporting and Compliance Engine (TRACE) requiring dealers to report trade information for US corporate bonds. Administered by FINRA, the scope of TRACE has been extended to other bond types over the years, including Treasuries and some asset-backed securities. In 2005 municipal bonds followed suit with the introduction of the MSRB’s Real-time Transaction Reporting System (RTRS). Outside of the United States, progress on ‘official’ trade reporting and transparency has been slower and patchier reflecting the more disparate market landscape. However, the European Union has introduced some reporting requirements under MiFID II and is considering the production of a Consolidated Tape (CT) for European bonds. The International Capital Markets Association (ICMA) also provides guidelines and recommendations on secondary market price dissemination. Dealer Quotations This valuation method relies on obtaining a ‘quote’ for a portfolio holding from a dealer or broker firm – frequently the trade counterparty. The number of assets that can be valued this way is larger than the traded universe, since dealers will typically have inventory on which they are willing to make a market even though an actual trade may not have taken place. Counterparties are also usually willing to support deals that they have been involved in or have sold to investors. The quality and freshness of these quotes can and does vary enormously. Many dealers will only update quotes infrequently and without much real care and attention unless required to ‘firm up’ the quote in response to real buy or sell demand. For the bulk of dealers, ongoing valuation support of a deal is a chore. Another more serious failing of counterparty pricing is that there is an inherent conflict of interest in using the same dealers or counterparties with whom trading activity is engaged to provide ongoing valuation for the trades resulting from that activity. It is in the interests of the dealer to keep their buy-side clients happy so that they will continue to do business with them, and producing a price that keeps the investor happy is never a good foundation for an objective valuation. Consensus / Composite Prices In recognition – tacit or implicit - of the issues surrounding single dealer pricing there have been several attempts to reduce the potential for conflicts of interest and quality issues by collecting quotes from a number of dealers and, usually after some basic statistical work, produce an ‘average’ quote for the asset. The most basic technique involves eliminating the highest and lowest quote values (or quotes falling outside some stated tolerance or standard deviation) and calculating an average of the remainder. Most of the vendors who are involved with the collection of dealer contributions also produce some form of average pricing. Where there are lots of different quotes from reputable dealer sources, this is an excellent approach, and it produces entirely acceptable and justifiable results. However, where there are only a small number of quotes available for a particular asset and/or the quality of the quotes are suspect then the technique can lead to a distorted output. Averaging lots of poor quotes does not magically lead to a good one – it is very much a case of ‘garbage in, garbage out’. ‘Mark to Market’ Valuations There are a wide range of techniques and methodologies used in the mark to market approach (sometimes known as evaluations, matrix pricing or benchmarking) but the key feature in all is that activity in the liquid, traded market will be extrapolated in some way to illiquid, thinly traded assets. The link between the active asset and the inactive asset is typically expressed via some form of spread. Several specialist providers of mark to market evaluations have evolved over the years in response to the need for updated valuations of OTC fixed income securities. The mark to market method allows for a significant expansion of valuation coverage since the non-traded and unquoted assets that would not be covered in the previous approaches can now be assigned a value. For the vast bulk of holdings, some variation on this method is the only way to produce valuations that can be updated in some kind of systematic and justifiable way. ‘Mark to Model’ Valuations In cases where more complex security structures are involved, or where there are few or no similar deal types actively traded, the only solution is to mark to model. This technique involves modeling the asset using either industry standard analytical packages or in-house systems, calibrating the models to reflect assumptions necessary to generate a valuation (e.g. probability of default, prepayment speed) and then periodically running the valuation engine using up-to-date market inputs (typically yield curves or swap curves). The mark-to-model approach is the only non-counterparty option available for many complex and bespoke structured assets, but its application should be handled with care. Complete transparency is necessary in this approach more than any other, since the assumptions and calibration of the model – and the choice of model itself – have such a huge impact on the end result. Poorly done and without total transparency it is less ‘mark to model’ and more ‘mark to make believe’.

Sources of Bond Prices

Official Reporting Platforms

In the US, FINRA runs the Trade Reporting and Compliance Engine (TRACE) for the corporate bond markets and the MSRB hosts the RTRS system for Municipal Bonds. Both disseminate reported trade information directly to users, but more frequently, via third party vendors. As sources of actual trade activity in notoriously opaque markets these are extremely valuable both as specific trade data and for benchmarking purposes. As mentioned earlier, there is no similar regime currently in place for non-US bonds, although the European Union is developing a consolidated tape for EU bond markets.

Trading Platforms

These systems offer the opportunity to trade traditional OTC products electronically and as a by-product, many provide market data on the trade levels which can be used for valuation purposes. Additionally, some of the larger trading platforms are parlaying this proprietary data into mark to market pricing products designed to challenge the incumbent evaluation vendors.

Dealers & Interdealer Brokers

As previously stated, outside of trades, dealer quotes are a key source of bond prices. Dealer pricing is available to the user in several different formats and channels. Desktop systems such as Bloomberg have dealer contributions in their services, either publicly available or via some kind of restricted ‘permissioned’ pages. The websites of the major dealers also offer pricing pages, again usually in a secure client login format and a common method of retrieval is in an ad hoc ‘manual’ fashion usually via email or electronic message. Supplementing the dealers are the Interdealer Brokers (IDB’s). The main Interdealer Brokers all have major information divisions which disseminate data drawn from their trading desks to users and vendors. This includes pricing from all the major OTC markets they trade – FX, money markets, interest rates, fixed income, credit markets and energy - and additional data such as curves for use in pricing models.

Valuations Vendors

Commercial valuations and pricing vendors are major players in the bond pricing landscape. The large financial information vendors such as Bloomberg, ICE, Refinitiv and S&P Global all have evaluated pricing units producing mark-to-market bond prices. These businesses supplement and add value to the core pricing and reference data services provided by the firms. There is also a range of smaller, more specialist companies who provide valuations on more complex, hard to price instruments or gather and disseminate composite prices or BWIC’s. In addition to those vendors who generate actual price levels there are many firms providing the underlying data used to populate and calibrate pricing models (such as yield curves, credit estimates and spreads, etc.). Many pricing models and analytics are themselves available commercially for licensing to end users. Finally, reflecting the rather technical and esoteric nature of the field, a slew of specialist consulting firms exist to provide advice and support for valuations and pricing. Some of these companies and individuals supply actual valuations to bond investment firms, others will provide some kind of specific assurance (negative or positive) on the prices or price levels used or at a more strategic level, providing advice and guidance on valuation policy, procedures, governance, methods and sources (including detailed due diligence of pricing vendors).

Final Thoughts...

Valuations – especially those of OTC products such as bonds – have been severely implicated in the recent financial crises. As a result, the methods and sources used by financial institutions to price their asset holdings has come under intensive and unprecedented scrutiny by policy makers and regulators and additional oversight and control has been mandated. With several options available to end users, depending on the asset type involved and the intended use of the valuation, firms need to be more aware than ever of the pros and cons of each method and source. They should also be wary of making assumptions about different valuations approaches without a detailed knowledge thereof. The choice of valuation methods – or more likely the mix of methods and sources – will be very much governed by a combination of factors. Firms should ultimately choose the method and source most relevant to complying with their regulations, governance and internal constraints.

About the BPI The Bond Pricing Institute (BPI – a Division of the Bond Dealers of America) was launched early 2022 within to bring together and represent diverse professionals engaged in the work of pricing evaluations of fixed-income securities for investors, funds, broker-dealers, insurance companies and others. The mission of the BPI is to promote professionalism and best practices in fixed-income securities pricing through advocacy, education, and communication. Improved pricing and valuation of fixed income securities to benefit investors is of primary focus.