Bank of America published its latest credit investor survey on December 18, which showed that the biggest risk investors are braced for in 2020 is market liquidity: only the second time ever that this factor has been uppermost in investors’ minds.
As for credit itself, investors are fully risk on.
“Spreads are tightening fast, and FOMO behaviour has been conspicuous of late (note single-B and CCC spreads are now ripping),” according to analyst Barnaby Martin, head of European credit strategy at Bank of America. “But there are almost no investor concerns next year on inflation, rising yields or an equity market correction.”
Given where the credit markets were at the end of 2018, it is perhaps understandable that bond buyers remain very focused on liquidity, or rather the lack thereof. This is a market where just 1% of bonds trade daily, and 32% of bonds trade on five or fewer days per year.
“In which other asset class do funds managing $3 trillion routinely guarantee daily liquidity to their end investors, whilst regularly taking weeks or even months to turn around their portfolios?” asked Citi’s Matt King in a report in early November.
However, King claimed to be heartened by progress that is now being made towards easing these concerns: “Recent advancements in the market mean we are on the verge of some of the biggest changes in this landscape for decades.” These advances relate to bond ETFs.
A big focus is on portfolio trading, which could be set to transform liquidity in the bond markets. By early November 2019 there had been more than $60 billion in portfolio trades year-to-date in US investment grade bonds alone, although only a small fraction of these replicated ETFs.
Matt King, Citi
“This has the potential to revolutionize how portfolio managers deal with outflows, and opens the way to ‘factor’ trading more broadly,” says King. “Rather than hitting the bid on a few liquid bonds, having to rebalance portfolios later and risking adverse selection effects, managers can simply choose to sell vertical tranches of their entire portfolio.”
The impact of this on market liquidity could be significant if more and more portfolio trades replicate ETFs. It is now common practice for individual dealers to work with ETF providers to put together a portfolio of securities that replicates and creates a new ETF, or to redeem an ETF by exchanging it for a basket of underlying securities.
“Any bond can now find a reasonable bid, provided that it can be presented as part of a broad portfolio which replicates an ETF,” King points out, calling this the “tetris” effect. “The subsequent ETF creation trade effectively zaps the entire portfolio from the dealer’s balance sheet.”
These portfolio trades don’t necessarily need to replicate the entire ETF, just a basket of bonds therein.
Any bond can now find a reasonable bid, provided that it can be presented as part of a broad portfolio which replicates an ETF- Matt King, Citi
So far, only a small fraction of portfolio trades have been replicating in this way. However, intermediaries have been quick to capitalize on the anticipated growth in portfolio trading.
Tradeweb was the first trading platform to offer portfolio trading for corporate bonds and by October 2019 had facilitated a total of $21 billion year-to-date. It now allows users to submit portfolio trades to multiple liquidity providers simultaneously.
“Portfolio trading is fast becoming a vital new liquidity source for institutional clients seeking to trade large, complex baskets efficiently,” says Chris Bruner, head of US credit at Tradeweb.
MarketAxess launched its portfolio trading protocol in mid-November. It offers clients the ability to trade up to 1,500 bonds and submit to up to five dealers.
“Portfolio trading is an important part of the new market-making model that is showing early signs of increasing overall market turnover in credit trading,” said CEO Rick McVey on a recent analyst call. MarketAxess estimates that it still represents just 2%-4% of TRACE volume, however.
“It is important to remember these portfolio trades create a lot of secondary liquidity around the tail risk that investors or dealers are trying to manage.”
Trading infrastructure platforms such as Tradeweb and MarketAxess see automation as the key to easing liquidity concerns in fixed income.
“I don’t see any reason why some form of electronic tool cannot impact the whole lifecycle of a bond from liquid index products at one end and at the other end private trades by appointment. You can use the same technology at both ends of the spectrum,” says Gareth Coltman, head of European product management at MarketAxess in London.
“The drive to passive has created cost pressure in clients. One of the ways to relieve this is to look for efficiencies in the fee process. The last thing they want is to lose margin as they execute.”
Gareth Coltman, MarketAxess
The opportunity for these firms is still vast: just 30% of US investment grade credit is traded electronically. But the pace of change is accelerating.
“We now see that around 30% to 40% of all prices we get from banks and liquidity providers are from algos,” Coltman tells Euromoney.
The hurdles to automation of bond trading remain considerable.
“E-trading can be a great help connecting together willing buyers and sellers of the same security and encouraging them to transact. It works well when there is relatively little debate about the correct price, and it is simply a question of finding the other side,” King points out.
“But for the vast majority of corporate bonds, it is far from obvious that at any one time there exists a willing buyer and a willing seller, even before we get to any discussion about whether there is a common price at which both would be prepared to transact.”
But the direction of travel is now one way: more and more credit will be traded electronically, and investors see this as inevitable. “The buy side has to become more efficient because they have no choice as there is more automation coming from the sell side,” Christophe Roupie, head of Europe and Asia at MarketAxess, tells Euromoney.
Market imbalance between the "buy side" and "sell side" aﬅer the global financial crisis
New issue liquidity
One of the big liquidity challenges that bond markets both in the US and elsewhere face is the reliance on benchmark new issues, which tend to be far more liquid than seasoned securities. This distorts portfolio weightings as managers sell older on-the-run securities to buy new issues.
MarketAxess recently launched a new protocol – Live Markets – designed to automate the post-placement process. “Historically this part of the market has always been difficult,” says Roupie. “The lack of transparency is the key pain point. Post placement of the new issue you are going from a grey market to an actively traded market.”
Christophe Roupie, MarketAxess
Live Markets will be launched in Europe in the second half of 2020. “The market is very distorted and heavily skewed towards new issues,” explains Coltman. “We thought that this would ease when the CSPP ended, but now the ECB is potentially moving back into that demand.
“Deals trade with a slightly different workflow in the first few weeks because clients may have been allocated more or less than they wanted,” he continues.
“Historically this part of the market hasn’t been electronically traded and has tended to be OTC. But because it is so liquid it is perfect for a more order-driven trading model.”
In a way, Live Markets is pushing at an open door as the new issue market is already the most liquid. Initiatives to improve the situation across the rest of the bond market will probably have the more important impact. And the ETF market will be central to this.
“The adoption of ETF share trading in a much bigger way by both dealers and investors is another way to move risk. So, you really see this whole new risk transfer model emerging, which we are excited about, because we think it will not only be healthy for our volumes, but it also comes with the prospect of increasing market turnover,” said McVey on the recent analyst call.
King at Citi is particularly enthusiastic about the impact that ETF replicating portfolio trades may have.
“We cannot state enough how transformational this process potentially is,” he emphasized. “Note that the original investor does not need to take the ETF: they simply get cash in return for their basket of bonds. Yes, the dealer then needs to find someone to buy the ETF, so if a large number of liquidations were carried out simultaneously, this could eventually become a problem.
“But the liquidity of the ETF is massively better than that of the individual bonds.”