Calmer waters ahead for corporate bond trading?

There is no doubt that the volatility and dislocation experienced in corporate bond markets earlier this year will go down in history. “March saw probably the most dramatic moves in credit spreads that certainly I’ve ever seen,” says John Cortese, co-head of US credit trading at Barclays. “These were moves in size and speed that were not even once in a decade — I had just never seen that before.”

The events of those dramatic weeks, before central bank action drew a line under it, provided a snapshot of a market in flux and raised questions about its future direction. The market was becoming increasingly electronified, but still reliant on traditional market making to function, particularly while under stress, and grappling with the impact of a growing universe of fixed-income exchange-traded funds (ETFs).

ETF disruption

The role of ETFs in March’s volatility has come under particular scrutiny. ETFs were predominately equities products until recently; however, 2019 became the first year when more capital was invested in fixed income rather than equities ETFs, according to the Financial Times.

In normal times, ETF share pricing should be broadly in line with the value of an ETF’s underlying securities, the net asset value (NAV). And any deviations are expected to be resolved via an arbitrage mechanism where so-called ‘authorised participants’ are able to trade ETF shares for underlying securities, and vice-versa, taking advantage of price differences to make a profit in the process.

In March, this process appears to have broken down. Against a backdrop of significant economic uncertainty, investors cashed-in liquid assets, such as fixed-income ETF shares, in high volume, pushing down prices. But during the same period, underlying bond market liquidity deteriorated, creating a disconnect between the two markets. At the height of market disruption, fixed-income ETF shares were trading at as much as a 5% discount compared to the NAV — an alarmingly high difference compared to normal market conditions. There are concerns that this rush to cash in ETFs, and the chasm in pricing, contributed to disorder within the bond markets as a whole.

The counter-argument is that ETFs fulfilled their role, allowing investors (including fund managers, themselves users of ETFs and under pressure from their own investors), to easily access capital in a time of stress, and priced for that accordingly. And the price disparity with underlying bonds, albeit stark, was a function of differences in liquidity levels.

Andy Hill, senior director in the market practice and regulatory policy team at the International Capital Market Association (ICMA), argues: “The corporate bond ETF market functioned. It did its job. I guess the bit that raises eyebrows is when you look at the disconnect back at the peak of the crisis between ETF prices and the NAV of the underlying bonds. But the counter-argument is that the ETF was the correct value; the prices for the NAV are irrelevant because you couldn’t trade on it.”

Mehmet Mazi, head of global debt markets at HSBC, shares this view. “ETFs were probably one of the few instruments that could be traded and they showed more of the fair market levels compared to the underlying bonds,” he says. “Really, the ETFs were trading at fair price and the underlying bonds were hypothetically at a premium.”

Disruptor or market pressure valve, March’s events were a particularly extreme demonstration of the sometimes brittle relationship between fixed-income ETFs and their underlying securities. “Ninety percent of the time, ETFs are a pretty efficiently functioning market,” says Mr Cortese, “But you get these instances sometimes where you get a clash between the ease of trading the ETF, which is fundamentally an equity product, with the slower moving risk transfer in the underlying bond market. It doesn’t happen often, but in the rare instances where it does happen, it can create severe dislocations in the market and material volatility.”

It is significant that, during this crisis, the US Federal Reserve opted to include ETFs within its secondary market corporate credit facility. This was the first time the Fed has ever made ETF purchases, signifying the level of importance it ascribed to stabilising ETF flows and pricing.

Widespread dislocation

However, the disruption in the market during March extended well beyond ETFs. Throughout the month, as the coronavirus was gaining a foothold in much of Europe and North America, and the prospect of economic uncertainty loomed large, bond markets came under increasing pressure. Mr Mazi says: “We saw the market lose liquidity in most areas, but there was technically supply, most probably related to redemption pressure from the funds, which led to forced selling. This caused disruptions and pricing dislocations.”

By March 23, US investment grade (IG) bonds spreads had reached 400 basis points (bps), in stark contrast to the more typical range of 100 to 150 bps. In high yield markets, movements were even more extreme, moving from around 400 bps to more than 1000bps. Much the same trend played out in European markets too, albeit a few days earlier. And as pricing became more volatile and liquidity stalled, there was a substantive increase in voice trading relative to electronic activity. In many cases, algorithmic trading, which was not designed to trade during significant market volatility, had to be switched off. 

Charlie Shah, head of US IG trading at RBC Capital Markets, says: “Events in March did expose the fact that when the market structure is challenged, and volatility really spikes, the flows become more high-touch and personal. Dealers are better suited to line up buyers and sellers, and investors trust the process is more efficient, rather than engaging an algo, which can sometimes exacerbate moves in a market that’s not functioning properly.”

A May 2020 paper from ICMA suggests that March’s events “reveal [the secondary corporate bond market’s] intrinsic core: a dealer-based market, where market makers remain the primary source of executionable prices, and liquidity is reliant on their capacity to assume and recycle market risk”.

It is certainly true that, at present (challenging conditions or not), the majority of activity continues to be managed via dealers using voice trading and, given the corporate bond markets’ idiosyncrasies, that is unlikely to change in short order. However, there is also little to suggest that March’s volatility will disrupt the market’s ongoing shift towards greater electronification or automation.

“I do think that the volatility in March was more an anomaly than a norm,” says Mr Shah, “and I believe the role of algos and automation will remain intact, and only continue to grow. It is only extremely volatile situations where the market ceases to function efficiently when algo pricing may be shut off.”

Christophe Roupie, head of Europe and Asia at fixed income electronic trading marketplace, MarketAxess, reflects: “Credit markets are esoteric by nature and liquidity can be scarce, especially in secondary markets where hundreds of thousands of bonds (or more, in the [municipal bond] markets) are available to trade for institutional investors at any given time. The warehousing of risk by dealers does facilitate the provision of liquidity.” But he adds that “market infrastructure shifts have been playing a huge role in bringing more efficiency and transparency to the fixed-income markets”.

For Mr Roupie, the proof of a meaningful shift is in the numbers, with the MarketAxess platform seeing its highest ever level of credit trading volumes of $660bn in the first quarter of 2020 — a 29% year-on-year increase. Specifically, Mr Roupie also believes that all-to-all trading, a mode of trading via platforms such as MarketAxess which directly connects a diverse range of global buyers and sellers, is playing an important role in providing alternative sources of liquidity as well as cost savings. During the first quarter of 2020, $209bn worth of trading was done via Open Trading, MarketAxess’s all-to-all platform — a 55% increase compared to 2019. Even during March’s turmoil, he reports that trading volumes via Open Trading remained strong and grew to almost a third of total volume.

Rise of portfolio trading

Another powerful and technologically-driven shift within markets is the growing popularity of portfolio trading, where a basket of bond securities (which could number in the hundreds), can be traded in one transaction. JPMorgan, for instance, reports that its US portfolio trading volumes increased 141% between 2018 and 2019, and by halfway through 2020, volumes had already reached 77% of their 2019 total. During the recent market volatility, portfolio trading became a valuable tool for efficient and cost-effective trading.

Much like with ETFs, this is a phenomenon that began in equity markets, but has now found its footing in fixed income too. With increasing electronification, and growing fixed-income ETF activity, it has become possible to corral vast amounts of pricing data from regulatory reported bond trades and ETF prices listed on exchanges, making it possible to efficiently price large and complex portfolios. Both banks and trading platforms, such as Tradeweb and MarketAxess, now offer this capability.

Mr Mazi comments: “It’s a challenging process to facilitate, in terms of infrastructure, as you’re dealing with tens of thousands of securities. And unlike in equities, you’re not dealing with lit markets and price discovery that is as easily observable. So, you need the right technology and robust infrastructure. We have invested a lot in this area over the past three or four years, and we’re seeing more and more interest in it.”

For the buyside, the appeals are clear. As Matthieu Wiltz, co-head of global credit for securitised products group and public finance sales at JPMorgan, puts it: “We’ve seen a huge increase in demand for portfolio trading from the buyside. The appeal being that it’s a solution that can provide quick pricing, efficient execution and trading the whole portfolio can be an effective way to reduce risk. As the size of the underlying market grows, so will this as a tool.”

For the sellside, the benefits are perhaps less clear-cut, but it clearly presents an opportunity to provide a service that clients value.

Unwinding central bank intervention

From a structural perspective, the market architecture of the bond markets does seem to be shifting, little by little. From a pricing perspective, the large-scale corporate bond purchasing programmes announced by central banks in the second and third weeks of March appear to have achieved their goal of maintaining stability.

Although it does pose broader questions about the long-term impact on the markets of continued central bank interventions. After several years of assertive monetary policy, there were already concerns that the market had become largely technically-driven, and somewhat divorced from fundamental valuations. A situation likely to be amplified by the latest quantitative easing (QE) measures.

Winifred Cisar, Wells Fargo

Mr Hill says: “It’s a double-edged sword because on one hand [QE] drew a line under it [market volatility]. And [QE] does provide a backstop for the market which helped to restore confidence. The flip side is, what does it mean for valuations? And it gets to a point where you look at the credit spreads, and to what extent do they reflect the fundamental value of the underlying bond? I think that becomes more of a worry longer term.”

Although there is a recognition of these risks, many bankers appear relatively sanguine about the situation, as they believe policy-makers’ main priority will remain shoring up the economy. Additionally, aside from monetary stimulus, there is already a significant amount of cash in the system, for example, with investors hungry for yield.

“A popular topic in the market is around how to exit from that support,” Mr Wiltz says, “but I don’t think there will be any rush for that. And when we look at the level of cash in the system, the credit business is in a sweet spot.”

On the US side in particular, there is also a sense that the Fed has not ended up needing to be particularly active in markets to make a difference, with the statement of intent seeming to have had a large effect.

Winifred Cisar, head of credit strategy at Wells Fargo Securities, comments: “The Fed’s action really gave investors confidence without needing to be aggressive in their buying, so unwinding it in that sense isn’t going to be a big issue.”

“Longer term, it is possible to argue about what the actual credit quality of a company or a bond is, [in the absence of] a central bank programme. And that thesis could get tested in the future when we do see what the real impacts of the virus are for different companies and the broader economy,” says Mr Shah. While he believes central banks have played a crucial role in market stabilisation, he adds that: “I don’t think, in the short-to-medium term, there are going to be negative ramifications for the market because central banks, especially [the Fed], have been buying primarily shorter-dated securities and so there are no real broader concerns surrounding an unwind.”

Cause for optimism

The news that several of the vaccines being developed appear to promote a strong immune response provides further reason for optimism. Ms Cisar, speaking in mid-November, comments: “The impact of the vaccine news has been outsized in terms of spread compression, with the high-yield market reaching an all-time low in yield. Investment grade has also seen some pretty tremendous spread compression. This makes for a fundamentally constructive environment; if the vaccine is 90% or more effective, it creates the expectation of business models getting back to usual.”

Viktor Hjort, global head of credit strategy at BNP Paribas, describes the credible possibility of a vaccine (particularly as developments become more concrete) as a key means by which markets will be able normalise, without a reliance on central bank intervention. “In some sense, the vaccine announcement is one way of getting to the root cause of the downturn,” he says. “And in some ways, that announcement is the equivalent in this crisis to the US Treasury injecting capital into banks to deal with a financial crisis 11 years ago. It’s obviously early days and Covid has had an ability to surprise us. But I think there is a template there.”

With the prospect of the end of the worst on the horizon, market conditions are likely to be less turbulent in 2021. Nonetheless, there could still be some difficult months ahead, particularly as Europe and North America grapple with the virus during the winter. “I think, going forward, we’re going to see a bit of a ‘tug of war’ between visibility around a reopening, related to when vaccines will be readily available, versus the current predicament we’re in where things are actually closing,” says Mr Cortese. “Ultimately that will get resolved, but it could be a choppier dynamic near term.”