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Pricing in volatile markets and potential regulatory impact

Pricing in volatile markets and potential regulatory impact

A combination of volatile and turbulent prices, challenges for valuation and the introduction of the US Securities and Exchange Commission (SEC) Rule 2a-5 means data specialists are more essential than ever for investment firms

The past year was hugely frenetic for markets. According to multiple sources – including Deloitte and Eurostat – Russia’s invasion of Ukraine and the resulting economic and political instability contributed to some of the highest levels of inflation seen in decades across many developed markets. In response to this, central banks began to tighten monetary policies, with investors suffering from negative returns, especially in equity and fixed income asset classes. 

In such an environment, the pricing of securities – particularly illiquid ones – can become more challenging. On top of that, investment managers are grappling with the SEC’s Rule 2a-5, which came into effect in September 2022 to provide a common fund valuation framework to be adopted by the mutual fund industry. 

All of this makes it more important for investment firms to be alert to how data specialists can help with pricing requests and transparency, particularly for illiquid assets such as certain fixed income securities. 

High inflation and volatility: problematic for pricing

Volatile and turbulent prices – a prominent feature of 2022 – can create uncertainty, making it harder to assess the value of assets, especially illiquid ones. 

Global equity markets have been very unpredictable. As of December 1, one‑month volatility in the MSCI World Equity Index – computed by averaging the daily change in price movement over 22 days – stood at 19 compared with an average of 11 for the previous 10 years, according to Refinitiv data

On the fixed income side, volatility has been similar. The yield on 10-year US Treasuries shot up by 30 basis points in January 2022 alone, after US Federal Reserve chairman Jerome Powell signalled that rate rises were on the way.  

The US Consumer Price Index (CPI) had been steadily rising since April 2022; it climbed sharply from 7.0% in December 2021 to peak at 9.1% the following June. Soaring energy and commodities prices in general – on the back of the Ukraine war – have been big drivers of this trend. The West Texas Intermediate crude oil price started 2022 at $76.08 and peaked at $119.40 in early March before dropping back to $81.62 on January 23, 2023. Similarly, the US CPI has since fallen but remains elevated, at 6.5% as of December 2022, Statista data shows. 

We’ve seen exponential growth in rates over the year from March 2022 to February 2023. The Fed fund rates have jumped from 0.25–0.5% to 4.5–4.75%. Similarly, in Europe, interest rates have soared from 0% to 2% since June 2022, with official data showing inflation had increased to 10.6% as of October 2022. As a result of the rate hikes, bonds were selling off all summer long. 

The UK also saw increased macroeconomic instability in the latter half of 2022. A principal cause of this was the mini-budget delivered by then-UK prime minister Liz Truss and the chancellor at the time, Kwasi Kwarteng. Their proposals to substantially reduce taxes, without any equivalent reduction in public expenditure, were met with a high degree of scepticism by financial markets. The price of sterling fell against the US dollar and Euro, further stoking inflation and prompting the Bank of England to accelerate interest rate rises. Another unforeseen consequence was that a large number of pension funds were forced to start liquidating a portion of their less liquid portfolios in order to raise collateral to meet cash calls on their derivatives positions.

There were periods when intraday bond yields increased by 100bp or more in a single session. It is worth noting that the fiscal policy proposed by Truss and Kwarteng has since been reversed in full by their successors, Rishi Sunak and his chancellor Jeremy Hunt.

Additionally, investors took a swift exit from Russian bonds following the invasion of Ukraine in February 2022. Uncertainty – and thus volatility – rose not just in Russian debt but in emerging markets more widely, driving bid/offer spreads wider. 

Refinitiv has been able to source trading quotes from market participants, creating a fair value level. According to Karl Mackelburg, director of fixed income at Refinitiv Evaluated Pricing Service: “After ruble settlement was suspended by Euroclear, we have been using observed quotes in markets where there is still visible action, such as Russian supranational issuance and US dollar-denominated Russian sovereign debt. This is important, because we do not expect to see brokers start quoting on such bonds again until 2023.”

In the US, Mackelburg explains: “Low-coupon municipal bonds have been hit hard by higher interest rates. Discounted municipal bonds are subject to capital gains tax, causing spreads to widen significantly. Also, significant muni-fund outflows forced fund sponsors to sell their most liquid assets.”

While some respected institutions argue inflation has peaked and will continue to slide, consensus is that it will be difficult to return target levels to 2%.

Valuation challenge

During the past year’s combined high inflation and volatility, pricing less liquid bonds accurately became a point of focus. One of the key metrics is whether there’s enough visibility of liquidity in the sector to give us a sense of where the price levels are.       

“Illiquid securities require more thorough analysis from our team and our clients. This is where pricing expertise, data and the right tools come into play,” says Joseph Hayek, who oversees compliance across the Refinitiv Evaluating Pricing Service. “The more we do on our end to substantiate value, the more comfortable our clients are with our prices.”

Another area of concern for investment firms – and one in which the Refinitiv Evaluating Pricing Service has provided support amid the recent volatile markets – is an instance where a bond is thinly traded. The more volatile and illiquid markets are, the less observable the data points, whether they be bonds, bank loans or structured notes. 

According to Hayek: “With less observable market data and, at times, too many observations, expertise in identifying the right information comes into play. We focus on employing experts from the market to ensure that pricing during volatile periods is performed accordingly.”  

SEC Rule 2a-5: top of mind

Investment managers of mutual funds operating in the US must, as of September 8, 2022, also comply with the SEC’s Rule 2a-5. The rule focuses on managing valuation risk, establishing a framework, third-party risk, board reporting and ensuring securities are fair-valued in good faith. 

Since last year, Refinitiv has seen this new regulation come to the forefront of discussions with clients, who want advice when reporting to regulators around fund valuation. With the wide use of pricing services to value securities held in mutual funds, the new regulation highlights the importance of overseeing the services. “This has added to the scrutiny in how services price securities since they are now overseen by their clients and auditors who want to ensure their obligations are fulfilled,” explains Hayek. “There has been a substantial increase in client engagement with key expectations that include using appropriate methodologies, enhanced transparency, managing fourth-party risk and potential conflicts of interest, and, in particular, price quality.”  

In the past year, Refinitiv’s Evaluated Pricing Service initiated several workstreams that focused on the above topics. Additionally, it engaged closely with clients to capture their requirements, in efforts to meet due-diligence expectations.

Evaluated pricing in 2023 and beyond

Over the past few years, the market has been volatile for three reasons: Covid-19 outbreaks, the Russia-Ukraine war and rising inflation. In the early months of 2023, the market appears to be focused on inflation only, and has accepted the fact that new strains of Covid-19 and the Russia-Ukraine conflict will continue for an extended period of time. In fact, global markets react and overreact to all inflation indications, including CPI, employment, retail spending, housing and energy prices. Pricing services must monitor these indications and adjust prices just as quickly as the market moves. With Rule 2a‑5, governance has become even more embedded into the investment management ecosystem, which ensures pricing securities are performed properly, and in line with market expectations.


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