The Value of Evaluations
INSIDE MARKET DATA FIXED INCOME SPECIAL REPORT
Evaluated pricing services for fixed-income securities have evolved over the years to incorporate the growth in credit derivative markets.
Inside Market Data spoke to Ian Blance, vice president of evaluation services for FT Interactive Data, about the drivers for change in evaluated pricing.IMD:
Has FTID's methodology for evaluated pricing changed over the last few years?Blance: The biggest change in our methodology… has been the incorporation of credit default swaps (CDSs) into the pricing of cash instruments. The emergence of the CDS market produced a situation that a lot of people would describe as the tail wagging the dog—because you're able to write a lot more CDSs than there is cash paper outstanding, you could get a better representation of a credit's performance.
Looking at cash spreads you may be influenced by factors other than just the pure performance of the credit… [whereas] the CDS market is much purer. It looks at the underlying performance of that credit and its likelihood of default. It was pretty clear to us that this is a very good indicator of what's going on with a particular issuer as opposed to a particular bond, and that this needed to be incorporated into our methodology. So at the beginning of the year we struck a deal with Markit Group to incorporate that information into our methodology.
IMD:
Is CDS pricing complementary to your traditional methodology?Blance:
We value the bond and not the issuer. So we still need to look at the peculiarities of a particular issue—the covenants, calls, puts and all of those specific factors. But in terms of driving the spread, what's going on in the underlying credit, as evidenced by the CDS markets, is a key piece of information.IMD:
There have been some issues in CDS pricing with regards to succession events and anomalous behaviour in spreads. How is that reflected in your methodology?Blance:
Ultimately we have an analyst who is responsible for the price. So while we're incorporating CDS pricing into our approach, the analyst always has an over-ride. We don't have a black box approach. We have people looking at anomalous situations, which aren't just in the CDS world. We don't rely on a single source or a single approach – we look at both quantitative and qualitative factors to reach an assessment on what we think is fair value.IMD:
What are the growth areas in evaluated pricing in terms of new instruments and geographies?Blance:
The biggest growth area recently has been in the structured finance world, in the asset- and mortgage-backed business, particularly in Asian and European ABSs and MBSs. There's an element of [those markets playing] catch-up with the US, where there has been a mature market for many years. The marketplace has now exploded in Europe and Asia. Another area is CDSs where traditional investors—our core marketplace—have been getting involved in the derivatives space as well as cash instruments.IMD:
Have there been any changes to the timing of evaluated pricing distribution and are there demands for intra-day pricing?Blance:
In North America… mutual funds need to deliver their net asset values (NAVs) to NASD, so typically [this was reported at] 3pm, which is when the Chicago futures exchanges close. But… a lot of mutual funds have interpreted their requirements as [needing] to take a 4pm New York valuation. Our approach had always been to take the 3pm treasury close of market and use that, but that's now changing… [and] we are going to be producing a 4pm snapshot.In Europe there is an intra-day valuation requirement for UK unit trusts. They have always had an intra-day snap valuation at 10am, 12pm and 2pm, which is something that we're looking at as well—whether we can service that marketplace through the day. Over the next couple of years the market will evolve to more frequent snapshots as opposed to a close of market approach. The technical infrastructure that we're working on today is designed to be able to achieve that.
You might find a two-speed market where the liquid [instruments are] being updated every 10 minutes or so, but the bulk of the market updates every hour or two hours. Certainly from our clients who are the administrators and operational people, it seems that… will be more than enough.
IMD:
Regarding a two-tier market, how will instruments that aren't liquid become more liquid?Blance:
I don't think they will. I think there will always be a two speed market—it will never evolve into a completely liquid marketplace. In the illiquid market we've seen a… shift towards privately-placed bespoke cash paper to meet specific requirements. I can't see any other way that you can come up with a value for that type of instrument [other than evaluated pricing].For securities that are liquid and lend themselves to the active trader marketplace, there will be an improved ability to see and execute trades. But simply having a marketplace isn't going to change the rump of the market that is held for different reasons. You're not going to turn all those buy and hold investors into active traders simply by providing an exchange to do that.
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