From the October 2007 issue of Research Magazine • Subscribe!

Shopping the Bond Market

It didn't seem this lunch was going to happen.

Tom Ricketts, president and CEO of Incapital, was taking a morning flight from Chicago, where the private investment bank is headquartered. On top of widespread delays and cancellations plaguing the airlines last summer, Chicago had fog conditions that temporarily shut down the airport. New York, meanwhile, was being lashed by one of those rainstorms that had been bringing its traffic to a standstill.

To add insult to injury, financial markets were going through their worst turmoil since 1987. The day before the yield on one-month Treasuries fell below 2 percent.

But in the end Ricketts made it to Midtown at 12:30 sharp -- beating out both his host and the photographer. Nor was he overly concerned about selling on Wall Street. Actually, he envisions a better environment for bonds, especially for investment-grade corporate bonds, going forward.

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Who: Tom Ricketts, President & CEO, Incapital

Where: Artisanal, 2 Park Ave. New York, Aug. 21, 2007

On the Menu: Watermelon salad, fondue du jour and investor education.

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"The yield curve has been flat for a long time," he explains. "This meant that investors incurred no opportunity cost by holding short-dated instruments or keeping their money in short-maturity CDs and money market accounts. Now that the yield curve has steepened, we are seeing extension trades, or a move to longer maturities."

In recent years, markets have been so receptive to risk that spreads between corporate bonds and U.S. Treasuries became too thin to attract investors. Demand for corporate bonds declined as some of the relative value left the product, admits Ricketts. This too is likely to change as markets return to more normal conditions.

Finally, callable bonds -- which allow the issuer to redeem some or all of the outstanding securities before their maturity date -- become more attractive when volatility goes up. That's because the embedded call options get more expensive in a volatile environment, giving investors a greater return.

Callable bonds should be even more attractive to retail investors, who make up Incapital's main market, than to institutions. True, if their bonds are called they risk being forced to sell and lose their income in a low interest-rate environment. However, unlike bond funds, they are not obligated to reinvest their money into other fixed-income securities. They can look around for more attractive opportunities in other markets.

Education ProcessThis is the kind of education process Incapital has had to do to build and maintain its business, which focuses on issuing and distributing fixed-income and structured securities primarily to individual investors.

Ricketts started the firm with one partner in the mid-1990s, after a career that included eight years as a market-maker on the Chicago Board Options Exchange. The business model was to get solid investment grade issuers to issue bonds the way that a retail investor would buy them. In other words, to make new-issue bonds as easy to purchase as stocks for an individual investor.

It took about a year, and a hundred presentations, to persuade its first issuer, GMAC, to gear a bond to the retail market. Since then, Incapital has co-launched a branded product, InterNotes, with Banc of America Securities and has underwritten some $50 billion worth of notes for top-notch issuers such as GE Capital, JP Morgan Chase and Lehman Brothers. Placed by Institutional Investor among its e-finance Top 40 firms, it now competes in its market niche with LaSalle and Merrill Lynch.

Ricketts doesn't claim Incapital created a new market segment, but he admits that it was the first willing to put elbow-grease into educating issuers and undertaking a large-scale marketing effort.

Says Ricketts: "The challenge was to persuade issuers to come out to the market on a regular basis, and to stay long enough for individual investors to make their decisions. We had to take the underwriting process and slow it down."

Bond issuers, who were used to dealing with institutions buying $100,000 worth of bonds at a go, had to accommodate investors putting $5,000 or less into their bonds.

Financial advisors, too, and through them their clients, had to be shown the advantages of new-issue bonds and of holding bonds vs. bond mutual funds or ETFs. Education remains an ongoing process.

The Role of TechnologyNone of this would have been possible without technology.

Incapital spends extensively on its technology platforms and maintains a number of websites for the benefit of advisors and investors. The websites explain its products, including structured products. Its LadderBuilder online tool helps advisors customize their clients' bond portfolios to meet very specific needs by selecting appropriate bond products, payment types, yields and maturities.

Incapital sends out a weekly list of available products to some 28,000 advisors in over 600 financial firms. However, it wants communications to be a two-way street. It not only talks to broker-dealers, but encourages a dialogue with individual FAs on how best to meet their needs. In developing products, especially structured products, Ricketts wants to hear from advisors and reps how exactly they need products to be structured.

"For a relatively small amount of principal," claims Ricketts, "we can offer a considerable degree of customization in our products, especially structured products. There is a fair chance that we could talk to the issuer and accommodate an advisor if he communicates with us. The hurdle rate is constantly coming down, the systems are now more scaleable than ever before, and better integrated. There is better risk management."

Although most of its customers are wirehouse advisors who work on commission, Ricketts says that Incapital can work with independent advisors. For instance, Incapital can structure products with no load or a smaller load, giving investors greater return if they already pay account-management fees to their FAs.

Industry Trends"We glean a lot of information about market and industry trends from the kinds of orders we get from our clients," says Ricketts. "We see what products are more attractive, what part of the yield curve investors are interested in. We not only take information in, but we can also dish it out."

Two current industry trends he sees as positive for his business: first, the impending retirement by baby boomers. As aggressive asset growth is replaced by the need for wealth preservation and secure, stable and steady income, he expects bonds to get more attention from investors. While he expects a cyclical shift toward corporate bonds in coming years, he also envisions this in the context of a slower, longer-term shift in portfolio allocations.

The second trend, which reinforces the first, is a higher level of sophistication among investors in terms of asset allocation.

"When they walk into their advisors' office, investors no longer want to hear the old 60-30-10 percent story," observes Ricketts. "They demand exposure to currencies, commodities, real estate -- an entire range of asset classes."

This requires advisors to gear portfolios to very specific needs of their clients. Incapital has been concentrating on structured products, which can offer investors customized risk-return parameters, with returns tied to any variety of benchmarks or underlying assets. Structured products, for instance, allow investors to benefit from the upside while limiting the downside. Some types of structured products can also address the need of having assets that have no correlation with the market. Many advisors are looking for such assets, especially as conventional asset classes become highly correlated.

Ricketts admits, however, that in the current environment structured deals have got a bad name. In this respect, he stresses the importance of advisors having a full understanding of the products they put into their clients' portfolios. For example, high-yield derived from a low-risk asset base invariably entails leverage -- something that was not well understood by investors hurt in the CDO meltdown over the summer.

"As the product base broadens," says Ricketts, "broker-dealers and advisors need more help with understanding products. It is the responsibility of the investment bank to help out with market education."

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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