By Ivy Schmerken, Editorial Director
With volatility spiking in global stock and bond markets, there’s been a profound shift in market psychology from chasing higher yields to focusing on risk in the credit markets, according to a recent webinar.
“Given the impact of rate hikes and supply in the markets and trade disputes, it’s really no surprise at all that clients have had some sensitivity in managing volatility,” commented Michael Noto, managing director, market structure, Barclays on the Greenwich Associates Dec. 11 webinar, “Liquidity in Credit Markets.”
Electronic bond trading platform Trumid has witnessed the shift in terms of a rotation out of riskier assets and into less risky assets, said Amar Kuchinad, chief strategy officer at Trumid. “You can see the buy-to-sell ratio on IOIs [indications of interest] and on orders,” he said. “On days when there is a lot of market volatility, you can see there is a lot more buying interest in investment grade bonds and more selling interest on high yield,” said Kuchinad.
Over the past six months, the cost of a transaction has jumped by about 25% on average, said Kuchinad, based on transaction cost analysis (TCA) conducted by Trumid on the platform. “It appears that people are willing to pay a little more to get the liquidity that allows them to manage their risk as they and their portfolio managers have decided they need to shift their portfolios,” he said.
Corporate Bond IPOs
In the past few years, a major source of liquidity in the corporate bond market has taken the form of new issues.
“2018 is the first year where the level of issuance is going to decline year over year,” said Ken Monahan, vice president of market structure at Greenwich, who moderated the discussion. High-yield issuance is down 35.3 % and investment grade corporate bond issuance has dropped 14.8% versus 2017.
Trades reported across the marketplace tend to be concentrated in new issues, said Trumid’s Kuchinad. Twenty percent of all trades reported to TRACE this year were in bonds that were issued over the prior five days, he said.
One of the main catalysts for the reduction in supply of new issues is higher borrowing costs resulting from rate increases. “There has been a lack of supply combined with pockets of volatility, and trade issues impacting a lot of industrial domestic issues have influenced the names [of corporate bonds] that investors buy,” said Noto.
While the participants are seeing increased bid-offer spreads and a lack of liquidity, this reflects more volatility in the market than it does the lower proportion of new issues this year, said Noto.
Despite the slump in sales of new bonds this year, Noto said that market analysts are not forecasting a decline in issuance for 2019.
ETFs Grow in Popularity
With concerns about liquidity in corporate bonds, investors are turning to exchange-traded funds, which track an index of the most liquid corporate bonds.
In a Greenwich survey of 60 respondents in 2018, 59% had plans to increase their usage of ETFs.
ETFs are viewed as a proxy for actual corporate bonds where liquidity has declined over the past ten years as new regulations have forced dealers to reduce their risk and inventories.
Scrambling to hedge their credit portfolios, bond investors have been betting against corporate bonds with two of the largest junk bond ETFs and indexes on credit default swaps, reported The Wall Street Journal on Dec. 11 in “Investors Bet $10 billion on Popular Bond ETFs.”
“The value of bearish bets on shares of the two largest junk bond ETFs hit a record $10 billion in recent weeks,” according to data from IHS Markit, wrote the WSJ.
To prepare for global credit events, on Dec. 14 Bloomberg reported in “Liquidity Fears Have the Likes of Pimco Sheltering in Credit Swaps,” that mutual funds like Pimco are turning to credit default swaps to express a view on widening credit spreads. With bond turnover stagnating, Pimco’s group chief investment officer Daniel Ivascyn told Bloomberg Radio that CDS indexes can deliver liquidity up to 20 times greater than a portfolio of cash bonds.
Can Platforms Fill the Liquidity Gap?
A big question is whether dealers will step in during spikes of volatility and sudden demand for liquidity.
“The primary liquidity providers in the marketplace felt more comfortable taking principal risk and using their expansive networks to work orders when the size of the trade was not too large,” said Noto.
Without the banks to execute large orders, the market is less liquid for big transactions.
Although the Greenwich survey showed that liquidity had improved for smaller trades in the $1 million to $5 million range, executing trades above $15 million is still a significant challenge and has not changed over the past three years. In 2018, 82% of corporate bond investors surveyed by Greenwich said it was still hard to execute bond trades above $15 million, as compared to 83% in 2017 and 85% in 2016.
Platforms targeting larger corporate bond trades are gaining traction. Trumid has close to 90 dealers on the platform and 400 firms altogether. While the minimum order size is $1 million, the average trade size is up to $3 million, he said, noting that blocks happen all the time.
Technology Improves Liquidity
While electronic bond platforms provide more avenues for fixed income investors, “they’re constrained by those who are contributing, so they go hand in glove,” said Jim Perrello, portfolio manager at Wolverine Trading.
Wolverine’s Perrello said he was optimistic that technology was improving on the part of the broker-dealer community and the algorithmic traders in pricing bonds.
Today technology is utilized for effective targeting of axes –- interest an investor has in buying or selling a bond, said Barclay’s Noto. Clients are able to target request-for-quotes (RFQs) and phone calls, and receive alerts in a particular name or industry, he continued. “Clients are getting more effective on how they take in the data and how they respond to quality axes that we are sending out and quality of IOIs,” he said. “Combine that with greater availability of pricing, that is increasing liquidity,” said Noto.
Electronic venues have also rolled out technology solutions that help aggregate data for investors or use IOIs to tease out “some natural liquidity without giving away information that is going to move the market against you,” said Kuchinad.
With the Federal Reserve raising interest rates and more than half of the $5.8 trillion corporate bond market rated BBB, the lowest rung above junk status, there is concern for how the market would digest a spike in demand for liquidity.
“On a micro level, on-a-daily-basis, there are spikes in demand for liquidity which increases the cost of liquidity,” said Kuchinad But, he said, there are providers on the sidelines, sometimes non-traditional dealers, that participate.
For example, Trumid has a new attributed trading protocol which is able to tell users which of their counterparties are the most likely to fulfill a particular axe or order they hold, and who they should be reaching out to, said Kuchinad. “All of this comes from the history of data, which firms are collecting from transactions and interactions, “he said.
Pointing to data science efforts, Noto said dealers are doing a good job of applying liquidity scores and understanding how bonds are responding to individual events. Thus, dealers use the data to see how specific bonds fit into the same liquidity profile which gives them more confidence in how to trade them.
Larry Fondren, founder and CEO of DelphX Capital Markets, said his firm has developed a platform that is focused on allowing dealers to provide on-demand liquidity without necessarily committing capital. The system is a neutral credit facility that issues two new types of securities to address unhedged credit risk on the sell side, and the need for higher yields on the buy side.
But there were doubts around dealers’ willingness to step in when there is a spike in demand. One speaker said that when dealers had 10 times the capital they have today allocated to their balance sheets, they were not that effective in identifying inventory.
In a live poll, 56% of respondents voted that venues and market structure will emerge to improve liquidity, while 49% expect that non-dealer market makers will contribute more liquidity.
One-third (or 33%) saw enhanced credit hedging products as improving liquidity, while 28% that volatility will enhance the return of dealer capital. Only 2% of respondents picked the most fatalistic option: “We are doomed.”
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