Are the bond markets ripe for a shake-up?

Bond markets have been unusually hectic in recent months. September 2019 was a big month for corporate issuance, with $304bn in corporate bonds sold globally, the second highest monthly value in the past five years, according to Dealogic.

At the height of mid-2019's rally, which took hold in August and was stoked by growing fears of a global recession, government bond yields, particularly in the eurozone, plummeted to record-low levels (perhaps most notably with German 30-year bunds reaching an all-time low of -0.31%). And some $17,000bn of bonds globally carried a negative yield.

Recent weeks have seen a reverse in fortunes. Greater optimism about a détente in US-China relations and improved economic data have driven yields back up. 

The end of the bull run?

There has been some speculation about whether this is the start of a longer term trend and the often-touted end of the 30-year bull run for bonds. But many in debt capital markets (DCM) continue to be bullish. For instance, Andrew Menzies, global co-head of corporate DCM at Société Générale, says the sector remains “a phenomenally attractive funding environment”.

Little has changed materially since before the mid-2019 rally. Daniel Shane, managing director, European investment grade syndicate, at Morgan Stanley, says: “A lack of supply is continuing to impact both US and European bond markets. On the US side, issuance peaked in 2017 and has been down for the past two years. In Europe, the numbers are up but this is largely down to a growth in reverse yankee transactions.” In Europe, the recent restarting of the European Central Bank (ECB) bond purchase programme will also be having a material impact on yields.

Is fiscal stimulus coming?

Although recent concerns may have lessened, the global economy is still fragile. And there is a growing feeling among finance policy chiefs that monetary policy has reached its limits and governments should be stepping in to provide a fiscal boost. Mario Draghi made this point strongly, and repeatedly, in his final weeks as ECB president, and his successor, Christine Lagarde, is of the same mind. Kristalina Georgieva, in her first speech as International Monetary Fund managing director, also spoke about the “central role” that fiscal policy must play in building a sound economy.

In private, some DCM bankers are sympathetic to this view and believe that greater levels of sovereign debt issuance are likely. Certainly in the UK, fiscal pledges have become a key part of campaigning for December’s general election and there is some speculation about what role fiscal policy will play in the build up to, and after, 2020’s US presidential election.

But it is arguably the eurozone that is most in need of such stimulus – and Germany is under the most pressure to provide it. However, in mid-November German finance minister Olaf Scholz said he did not believe there was any need for fiscal stimulus as there was “no crisis” in the German economy.

Even if fiscal stimulus does materialise, there is no direct link between debt issuance and bond yields. Only if, and when, economic growth prompts central banks to increase interest rates would an impact on yields be likely. In the short term, the bull market seems unlikely to change drastically.

Favourable conditions

With market conditions remaining favourable, corporate issuers are continuing to restructure their debt, for example, over longer maturity periods. Jeff Tannenbaum, head of Europe, the Middle East and Africa DCM at Bank of America, says: “With current market dynamics and absolute rates, we are seeing a large number of clients optimise their debt stack in terms of lengthening duration and buying back short-term debt to remain cash neutral.”

In the past there have been concerns that the cheap funding environment has allowed companies to become overleveraged. As of June 2019, BBB rated bonds (the lowest credit rating above high-yield status) represented 50% of all investment grade debt in the US, up from 33% in 2009, according to a recent BlackRock briefing note.

This is of potential concern as in an economic downturn, overstretched companies may struggle to repay or refinance their debt, which could lead to bonds being downgraded. Many investors are unable to hold high-yield bonds under the terms of investment mandates, and would be forced to sell, potentially creating market disruption.

But such fears have diminished as the funding environment has remained affordable and a sudden downturn seems relatively unlikely. DCM bankers also report that in general issuers are being measured in their approach. “The main use is refinancing and to cut down on the cost of debt. People are rationalising rather than releveraging,” says Fred Zorzi, global head of primary markets at BNP Paribas. “This is not a risk-free market, but things are comfortable at the moment. This is a very different market to in the past; there is much more caution,” he adds.

Changing business models

Outside of day-to-day concerns about market dynamics, technological innovation is creating the possibility of longer term change. Technological disruption within bond markets has been slower compared with other markets, such as equities. At a simple level, this is often ascribed to the fact that bond markets are larger than equity markets, cover a wider range of products, and liquidity is more diffuse. Bond trades are often high value and can involve products with complex structures that may be traded infrequently. Given these factors, most trading still takes place over the counter, with human intermediation.

Electronic bond trading platforms are aware of the challenge they face. “Our biggest competitor is still the voice market, with its flexibility and adaptability to make very bespoke solutions. In the short term you’re not likely to see electronification of highly bespoke products. But we endeavour to keep innovating,” says Frank Cerveny, global head of sales at European electronic fixed-income trading venue MTS.

There has been a more significant shift in areas where there is higher liquidity and, for government bonds especially, electronic trading is now commonplace. As markets innovate further, and seek to increase liquidity, there is an expectation that more corporate bond trading will electronify.

In particular, the ‘all-to-all’ trading model that electronic venues offer (alongside other trading models) disrupts the traditional divide between dealer-to-dealer and dealer-to-client market structures. All-to-all aims to increase liquidity by allowing a diverse range of global buyers and sellers to connect directly. MarketAxess, one of the world’s leading electronic trading platforms, says its all-to-all solution, Open Trading, now accounts for 27% of its total trading volumes. 

Platforms such as MarketAxess and MTS have also added automation tools to some of their solutions, which allow traders to set up rules and parameters that dictate what, when and how their trading should be done, effectively leaving an algorithm to do the leg work for them. Gareth Coltman, global head of trading automation at MarketAxess, says the idea is to allow traders to increase the scale of what they are able to do automatically and free them up to focus on wider strategy.

As electronic trading capabilities grow, bankers are shifting staff attention away from handling smaller flow trades and increasingly focusing on larger and more complex business, and creating bespoke solutions for clients. Mr Menzies at Société Générale says: “It is not about being a flow business any more. We are obsessed with adding value for clients and being the best on advisory.”

Modernising Issuance

It is not only on the trading side where there is scope for innovation. Corporate bond issuance has long been regarded as an overly cumbersome process, typically involving repeat rounds of phone calls and e-mails between banks and investors, to gauge initial interest, discuss pricing and take orders.

As with bond trading, one of the greatest hurdles to modernisation has been the sheer variety of different products in the market. But some platforms are emerging that aim to streamline the syndication process. One such is DirectBooks, a technology company backed by nine leading global banks: Bank of America, Barclays, BNP Paribas, Citi, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo.

The platform will aim to increase efficiency by digitising the process and consolidating information into one place. “DirectBooks will increase the efficiency and accuracy of deal workflow information among market participants by disseminating it through a robust communication platform that can be integrated into underwriter and investor systems,” says DirectBooks CEO Richard Kerschner. The firm expects to begin beta testing with clients in early 2020 and will initially work with US dollar-denominated investment grade corporate bonds, with the aim of expanding into other fixed-income assets in the future.

Smaller start-ups are seeking a share of the pie too. UK-based Nivaura, which was founded in 2016 and whose backers include the London Stock Exchange Group and Santander Innoventures is one such example. It aims to simplify and automate the end-to-end process of issuing financial assets, including bonds.

Richard Cohen, general counsel and legal product architect at Nivaura, says: “By conservative estimates, in general we think using the platform can save 50% of the time involved in the issuance process, and for some products up to 80% of the time. That time can instead be devoted to advising clients and structuring products around their needs.”

Expansion of ESG issuance

Environmental, social and corporate governance (ESG) issues – particularly climate change – have come to the fore as a global concern in 2019, and green bond issuance has likewise ratcheted up. Green bonds are becoming a well-established part of the capital markets landscape, with the first issued more than a decade ago in 2008. More recently, green bonds have been joined by social bonds, which support causes with a positive social outcome (for example, aiding people living in poverty), as well as sustainability bonds (a hybrid of the two).

According to Dealogic data, about $231bn in green, social and sustainability bonds had been issued as of the third quarter of 2019, compared with $179bn in 2018. Although this represents a substantial amount of investment in environmental and social causes, it is still only a small fraction of total bond issuance, which amounted to $6590bn in 2018.  

Nonetheless, for market participants The Banker spoke to, there has been a palpable change in the past year from ESG being “fashionable” to becoming something people are genuinely committed to.

Mr Shane at Morgan Stanley says: “I think ESG is one of the biggest stories in bond markets at the moment. There has been an incredible change this past year, which hasn’t filtered through into the data yet, but ESG is now very much a part of the assessments happening around every deal.”

There continues to be debate about whether ESG is a growth opportunity or an issue that should be viewed through a different lens; that is, ethics rather than profit-led. For Société Générale’s Mr Menzies, it is less about market expansion and more about ESG becoming something of the status quo for bond issuance. “People talk about it as a market growth opportunity but I think much of it will be about replacing ‘vanilla’ bond issuance. It should be fundamental to what we do,” he says.

Transition bonds

With the ESG sector in its relative infancy, it is arguably still in its ‘low-hanging fruit’ stage, where it is relatively easy for governments and corporates to identify unambiguously green and social causes to invest in. In the longer term, as the sector matures, more nuanced judgements may be required.

One such area that looms large is climate transition, where companies that currently have high carbon emissions and may struggle to meet green bond criteria, will need to raise finance for projects to help them to become less ‘brown’. BNP Paribas has been an open supporter of a new category of bonds that could provide such companies with a funding vehicle for improving their environmental footprint.  

Giulio Baratta, head of investment grade finance, DCM, at BNP Paribas, says: “As a bank, we have made our position clear on the importance of investing in climate transition. We need to see a broader range of organisations being supported via sustainable finance.”

For Mr Baratta, the recent UN Sustainable Development Goals (SDG)-linked bond issued by Italian energy company Enel could offer a blueprint for how to approach this challenge. Prior to issuing its SDG-linked bond in September, Enel had been a regular issuer of green bonds. However, it was keen to extend the reach of its sustainable financing and wanted more flexibility than green bond criteria would allow. Its SDG-linked bond allows it to use the funds for more general purposes. The company has, however, pledged to increase its installed renewable energy supply to at least 55% of its total by the end of 2021. And if it fails, the bond’s coupon will be stepped up by 25 basis points.  

“Embedding key performance indicators into the Enel deal was a groundbreaking innovation,” says Mr Baratta. “It was important for providing accountability for investors, who themselves are coming under pressure to justify their investment choices in this space.”

Whether the idea of so-called 'transition bonds' will take off in the same way that other ESG-linked bonds have remains to be seen.