Stars Are Aligning For Once-Maligned Retail E-Bond Mart Shane Kite (shane.kite@tfn.com), Senior Staff Reporter

A convergence of trends are brightening the outlook for retail online bond trading, turning the less-hyped cousin of Internet stock trading into a viable sales channel for dealers and buy-side firms alike. The soured equity market, a risk-averse baby-boomer generation and an increased focus on wealth management among buy-side firms, have combined to help reignite a sector that had dried up after the tech boom went bust.

"I've been in the fixed-income business for 16 years, and it used to be that you couldn't get anybody to talk to you at a cocktail party; you'd just sort of sit in the corner with a drink in your hand," Brad Wendt, president of BondDesk, said only half-jokingly. "This current environment has really changed that; it's a good spot to be in."

A rise in investor usage of platforms like BondDesk, ValuBond and TheMuniCenter that began in response to last summer's volatile stock market has continued into 2002, these firms say, due in no small part to continued equity market uncertainties. While it's unclear whether the rise will follow the trajectory that TowerGroup has predicted, in which retail online bond trading will increase 40 percent by 2005 from the 2 percent-to 5 percent that was Web-traded last year, this year's statistics so far support a growth scenario for retail platforms.

Ticket counts for BondDesk's online dealers are up 40 percent from the first of the year and 100 percent from a year ago, the firm said. Mill Valley, Calif.-based BondDesk reaches more than 6 million individual investors through e-brokerages such as E-Trade, TD Waterhouse, Vanguard and Harris Direct. Founded in 1996, BondDesk's dealer-backers include Bear Stearns, Goldman Sachs and UBS PaineWebber. The firm is writing 7,000 to 9,000 tickets daily, and said the count is increasing monthly at a 10- percent to 15-percent clip.

Web-savvy baby boomers reaching retirement age comprise the emerging demographic most contributing to increases, experts say. That factor is cited by most firms as providing continued growth in the sector, as strategies like bond "laddering"-in which a bond portfolio is constructed to have equal amounts invested in maturities within a given range to reduce interest-rate risk-become more popular and better understood.

John Schaefer, chairman-elect of the Securities Industry Association, calls this boomer phenomenon a "demographic tidal wave about to wash over" the industry, and "clearly where the money is." Firms are increasingly targeting the group through online channels, particularly in bond sales. People ages 55 to 64 represent the fastest-growing age group over the next decade and boast the highest average household net worth in the nation.

Perhaps Schaefer's selection as SIA chairman (for 2003) is telling. He also serves as president and COO of the individual investor group at Morgan Stanley. In advising on future directions, he recently urged SIA member firms to devote operations to client-centric services, such as 24x7 access and real-time account updates, to capture the boomer windfall.

The industrywide focus on improving service, particularly among sell-side firms, which was first attempted several years ago, is now more understood by retail traders. Customers' distrust of brokers' operations and research reached all-time highs this year, and turning these perceptions around has become a fairly critical business mandate for Wall Street.

"That's what firms should be doing, and that's what a lot of firms have been trying to push their people to do, believe it or not," said Charles Almond, CEO of BondDesk. "I doubt that very many people did it at the level that their firms wanted several years ago and as a result, a lot of assets that could have been preserved or increased are gone. They're gone because they kept trading for volume, because they like commissions, but the industry has been trying to get their reps, their brokers and financial advisers to move away from that and try to get on the same side of the table as their client, by essentially converting stockbrokers to doing more financial planning, asset allocation -being a manager of managers-either through a series of mutual funds or through a firm's in-house wrap business.

"It's not a selfless thing," Almond continued. "It's because they know that it's better than being in some kind of short-term, transaction-churning strategy. This isn't about transactions anymore. If it is, you're in trouble, because E-Trade can do it a lot cheaper than Merrill Lynch can. It's about helping people plan their financial future. That trend helps our business, especially because it helps financial advisers or even individual investors who are inclined to learn the tools, do everything that an average fixed-income money manager might do for a client."

BondDesk tools include real-time credit ratings so investors know if the bond they hold is on credit watch vs. waiting for a downgrade. The platform displays real-time pricing of live, executable inventory from multiple dealers. Financial advisers and individual investors can query the multidealer inventory pool and compare the pricing of similarly rated bonds. Among offerings involving the same Cusip ID, users can see the depth of the book on both the bid and ask side from the dealers.

But are Joe and Jane Public ever going to understand the bond market enough to trade bonds in volumes like they do equities? "Probably not in my lifetime," said Bubba Bennett, director of fixed-income marketing at Prudential Securities. "It's one thing to say at a cocktail party, I bought Cisco today at X price.' But you never hear anybody say, I bought New York State Thruway at a 6 percent 30-year par today.' Bonds are buy-and-hold, and equities are a trade-managed investment vehicle.

"However, price transparency is coming, and in my lifetime," Bennett added. "So if you're a mom-and-pop investor, you're going to make your choice based upon service and relationship, because I don't think price is going to be an issue. I definitely think it's going to get to a point that no matter where you go, it's basically going to be the same price. So it's going to boil down to services and ideas and how you manage the portfolio based on individual clients' risk profiles." Bennett takes BondDesk listings into Prudential's system and feeds the best offerings out to his financial advisers.

Because few individual investors are willing to do the homework alone on bond strategy or search for specific issues, marketing and service are the linchpins of success for retail e-bond trading. In most cases, such efforts have yet to produce monetary results. For example, a regional dealer that scrapped its voice-based system for BondDesk's centralized pricing recently described the effects of the move on the firm's profit-and-loss category as "fairly static." However, the system has freed up his salesman and traders to look for value-added trades for the firm's constituents, marking a shift to a more disciplined, long-term, client-centric approach to boosting profits vs. seeking short-term results. As the demographic movements come to fruition, expect a jump in retail e-bond marketing efforts, experts say.

Another macro trend driving the sector is convergence. The restrictions lifted between banks, brokerages and insurance companies in 1999 by the Gramm, Leach Bliley Act has created "a mad rush to the middle" by firms seeking to become a financial supermarket for their customers. That race continues, as firms open online channels for increasingly savvy audiences that are more self-directed in their investments and accustomed to being empowered to reach into the market directly. This includes not only bond-oriented boomers but also a more financially minded group of Gen-Xers and twenty-somethings.

"They have very different objectives and those objectives are met with very different products," said John Pigott, CEO of ValuBond. "So you see banks, brokerages and insurance companies-firms that have never been interested in selling bonds to their customers-suddenly wanting to call themselves a full-service provider. To be able to do that, they have to sell bonds to their customers."

Atlanta-based ValuBond has a relationship with multiple online brokerages, including stakeholder Charles Schwab. For Schwab, the firm pumps municipal inventory into the discount broker's trading engine. ValuBond has a back-end trading engine that cross-matches Treasuries, agencies, corporates, municipals, CDs and other products, as well as a front-end dealer-screen that resembles a Bloomberg mock-up aimed at smaller traders who want to have some level of direct Internet access. About 200 bond-trading desks subscribe to the dealer tradestation, Pigott said. These dealers feed their inventory into the transaction engine each morning to be displayed to the other dealers on the system. The same inventory is displayed to other customers on ValuBond's second front-end product: a private-label online bond brokerage, which is the offering that retail investors see. ValuBond spent two years and $10 million building its online bond brokerage, Pigott said.

"Their options are either to go with a traditional buy or develop their own in-house bond brokerage, or they implement a technology solution," he added. "So it becomes an efficient way for convergence players to enter into fixed-income markets, not to underwrite securities or to position-trade or to try and play that interest-rate guessing game, but for the purposes of satisfying retail investors' demands for full product selection."

The firm picked up 40 private-label sites last September when it bought BondExpress, a decade-old inventory posting service. ValuBond also deploys its system to portals like Bondsonline, Bondpage, CNNfn.com and Yahoo!Finance, which in July was rated by Barrons as having the No. 1 retail bond site on the Internet.

"As to ValuBond, essentially, the electronic trading system has been the lifeline that supports not only my brokers but also my retail clients," said John Ladensack, SVP for capital markets at Charles Schwab. "The brokers use the electronic system to select and trade bonds on behalf of clients, and clients use the system to go on to search, get information and make a decision with that help to buy bonds online.

"ValuBond fills in the holes for our municipal bonds that we currently own in our position," Ladensack added. "So I can't own enough bonds to survey the national footprint, but with the several hundred clients that participate on ValuBond sending me copies electronically of their product that I can trade and execute against, it compliments and fills in the gaps on the municipal side."

Schwab currently receives about 3,500 unique line items of municipal bonds from ValuBond everyday. "That number tends to grow as they add new providers and take existing providers that are not currently enabled electronically and convert their old-style stuff to an electronic transmission," Ladensack said.

Despite the progress, there still exists a "massive, fundamental need" for an updated infrastructure in the sector. "Fixed income is really the last group of markets that have just not laid pipe down to facilitate electronic trading," Pigott said. "From our side, we're a plumbing company, so we can lay pipe and be profitable at it."

TheMuniCenter does not sell directly to retail, but sells to brokers, investment advisers and money managers, which either sell or manage retail funds. "We have a significant number of trades that are for retail clients. You can tell by the trade size," said Tom Vales, CEO of TheMuniCenter. Based in New York City, the anonymous B2B system went live in 2000, backed by Merrill Lynch, Morgan Stanley, Salomon Smith Barney and Chapdelaine & Co, and distributes inventory among 500 participating firms.

Vales views the firm's platform as a way to smooth a transition from simple equities trading to more complex fixed-income diversification, for both customers and dealers, who must sell the bonds-or more accurately, make them understood to their customers-vs. simply providing execution services.

"Typically, an older client is going to start diversifying more into fixed income or you get into periods like now where you have volatile markets and people are moving cash out of equities and into bonds," Vales said. "For a typical broker to sell an equity stock to ma and pa is relatively simple, but for him to sell a municipal security or other credit spread instruments to ma and pop, that whole process before used to be cumbersome and difficult and a lot of firms would end up putting their clients directly into mutual funds. Now, with TheMuniCenter, you can reduce not only the time for bond execution, but the transparency becomes significantly greater to get a representative pricing of securities."

A trader at Fleet that uses TheMuniCenter said the platform is particularly useful when trying to fill a specific inquiry. "This allows a fine-tuning of portfolios to a greater extent than I think retail ever could before," she said. "High-premium housing bonds we filter out, but for the very plain vanilla we show MuniCenter to all of our reps. This way, when they're on the phone with a customer that's thinking about either a 5-, 10- or 15-year muni, the rep can just click on MuniCenter and see about in any area what's available and what the rates are like."

In Europe, London-based Bondscape, the online bond-trading platform for retail private clients developed by Barclays Capital and Winterflood Securities, has extended its product coverage and introduced a new online research tool. Barclays is using the platform as it plans to pare down 10 percent of its private banking unit.

The platform now includes 50 European government bonds and more than 70 euro-denominated corporate bonds with continuous, live two-way prices and no minimum dealing size. Bondscape has also partnered with europrospectus.com to offer registered users online access to prospectus information on euro-denominated corporate bonds, U.K. gilts, index-linked bonds and European government bonds.

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