Is the bond market rigged?

Late last week, Goldman Sachs (GS) disclosed that regulators are probing how it allocates and trades bonds. Citigroup (C) is reportedly in regulators’ crosshairs as well, along with the rest of Wall Street. At issue is how banks decide who gets to buy into bonds when they are initially offered.

Take last year’s massive Verizon deal (VZ). Wall Street dealers received orders for $100 billion in bonds. Verizon sold $49 billion, with about a quarter of that debt going to two firms, bond-fund behemoths BlackRock (BLK) and Pimco. Understandably, some feathers were ruffled. And this appears to be what the Securities and Exchange Commission and potentially other regulators are looking into.

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But is this really a job for regulators? It’s not surprising that a good chunk of a hot deal would go to Wall Street’s two bond powerhouses. Their size means they pay a large percentage of Wall Street’s commission. And even some of those unfairly treated managers seem to accept the situation:

Mary Talbutt, portfolio manager and trader at Bryn Mawr Trust Co., which oversees about $1.4 billion in fixed-income assets, said she put in an order for about $1.5 million of Verizon bonds but didn’t receive any. She said she didn’t really have a problem that larger funds got more bonds, noting that is just how capital markets work.

“I’ve been doing this for so long that you just kind of get used to it,” she said.

But there could be something else at play here.

Most bond deals start with the distribution of an offering document, which includes info about the selling company and a credit rating. Bankers then call up or e-mail bond managers, like BlackRock or Pimco, and ask them how much they would buy and what they would pay (or what yield they are looking to get). Underwriters then use that information to determine how to price the deal, you would assume at the lowest interest rate they can get that will allow them to place all the debt that the company is hoping to raise.

The problem, as you may have suspected by now, is that it doesn’t go down that way. Two years ago, Barclays’ credit research team, headed by Jeff Meli, took a look at investment grade corporate bond offerings and found that, like IPOs, bond deals tend to have pops. On average, the price of a newly issued bond rises 0.14 percentage points more than similar existing bonds between the time it is first sold to when it’s added to the Barclays Aggregate Bond index, which happens on the last day of the month in which the deal came to market. What’s more, more than half of the price increase happens on the first day. That means there are a whole bunch of investors not getting a piece of bond deals that would be more than willing to pay more than the initial asking price. Peter Tchir at TF Market Advisors appears to have done some similar research getting similar results.

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A bond manager who is able to get in on every new issue could expect to outperform his rivals by 1.05 percentage points, the Barclays authors assert. Considering the average yield in the corporate bond market is around 3% these days, that advantage is sizable. All of this suggests that Wall Street is paying off one client with money from another. Corporations sold $1.1 trillion in investment grade bond deals in 2013. That means bond investors who got first access to these deals pocketed nearly $12 billion that could have stayed in the accounts of borrowers, creating a pot of money that potentially Wall Street is rationing out to its best customers presumably in return for more trades later.

Some suggest that an investigation into underwriting practices could pose a problem for Wall Street as bond sales are rising while regulators are cracking down on trading. But that misses the point.

Wall Street firms still make far more money on their bond trading desks than they do from underwriting fees, even if that spread is narrowing. Goldman, for instance, generated $2.4 billion from debt underwriting in 2013. But it got $8.7 billion from its fixed-income trading business, which also includes commodities and currency trades. So you could see why Goldman would be willing to stiff its underwriting clients to keep its trading business flowing. And among the biggest banks, Goldman probably has the least to lose in the underwriting business — it’s ranked sixth in investment grade corporate bond fees in 2013 — and the most to gain in its trading business, which could explain why it is the first to come under investigation. Citi, too, ranked behind JPMorgan Chase (JPM) and Bank of America (BAC) in investment-grade bond deals.

So why is this being investigated now, when these practices have probably gone on for a while? For one, with interest rates at all-time lows, bond investors are complaining louder about the unfair edge that the bigger players enjoy. For the same reason, the stakes of getting into prized deals like Verizon’s, which yield slightly higher interest rates. Also, as too-big-to-fail banks have gotten even bigger since the financial crisis, it may be harder for corporate borrowers to take their business elsewhere if they feel like they are getting a raw deal.

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While the preferential treatment to big bond funds may seem unfair, it’s unclear it’s illegal. Matt Levine seems to think there are a number of plausible and legit reasons certain bond investors get preferential treatment. Corporations might value placing their bonds in the hands of a fewer large bond managers. But the fact that prices are rising suggests there is buying and selling, and issuers probably end up with a jumble of investors anyway.

What’s more, underpricing deals is accepted in the IPO market and, after the Facebook (FB) debacle, practically encouraged. After the IPO boom of the late 1990s, Wall Street firms were fined and sued for manipulating IPO offerings. But the fines were small by today’s standards. Goldman and Morgan Stanley (MS) paid a $20 million fine each. And Wall Street firms collectively paid $586 million to settle a class action suit on the matter.

In the class action, regulators gathered evidence that Wall Street firms were receiving higher commissions or other forms of kickbacks in return for giving certain investors special access to rigged IPOs. That would be much harder to prove in the bond market, where commissions are often built into the price that investors pay for their bonds, and the market in general is much more opaque. On top of that, few individual investors directly buy bonds, so drumming up resources inside the SEC or another agency might be tough, especially when the impetus of the investigation appears to be one part of Wall Street complaining about another.

All this suggests that we’re not really all that likely to see a crackdown of Wall Street’s shady bond underwriting practices, even if one is actually deserved.