Corporate bond market participants are starting to look for alternative ways to trade bonds as regulations put the squeeze on the amount of liquidity in the banking system. 

In the heady days before the financial crisis, investment banks operated as huge capital markets emporiums, offering investors and companies an array of products and services sourced from inventories held on dealer balance sheets. All that has changed, with new regulation requiring banks to hold more capital, refrain from proprietary trading and withdraw from many of the funkier funding structures they employed previously.

The effect has been twofold, on the one hand curbing bank excesses but on the other restricting choice. Nowadays when investors seek out the latest must-have security, they often find the doors to the emporium are closed.

An asset class to have been hit particularly hard by the new atmosphere of austerity is corporate bonds. These securities never enjoyed the liquidity seen in sectors such as equities and foreign exchange, and were hit especially hard by increased capital and funding costs because of their long maturities and embedded credit exposures.

Liquidity drop

Dealer holdings of corporate bonds are not reported in Europe but data from the US Federal Reserve offers some clues to the extent of bank corporate bond divestments in recent years. That suggests dealers have cut inventories by between 75% and 80% from their peak of $235bn in 2007, with banks now holding about $50bn of corporate bonds on their balance sheets, or less than 1% of the total market. Goldman Sachs, in a research note published in September, said short, gross and net positions declined by 27%, 21 % and 13%, respectively, between year-end 2012 and year-end 2013. Goldman put the total drop in inventories from their peak at about 40%.

“There are different estimates of the numbers out there, depending on how the inventories are measured, but there is broad anecdotal evidence that shows the liquidity has dropped sharply,” says Frederic Ponzo, London-based managing partner at consultancy GreySpark Partners.

“For the corporate bond market, this is a particular concern because there are thousands of bonds in circulation with different coupons and maturities. For a trade to happen you need a buyer and seller for the same bond at a price they can both agree on and at the same time. The probability of matching all those variables is low and that is why dealer warehouses played such an important role as they were able to take the risk onto their balance sheets for a period before finding somebody to take the other side of the trade. Now they are much less willing to do that.”

The key pieces of regulation to have impacted dealer appetite for corporate bonds are the so-called Volcker Rule in the US and the Basel III leverage ratio capital framework, which is set to be implemented in 2015. The Volcker Rule refers to Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and is named after proposals from former Fed chairman Paul Volcker. The rule aims to restrict US banks from making speculative investments not related to the interests of their customers, and has led to an exodus of traders from large banks to hedge funds. A similar rule was proposed in January by the European Commission.

The Basel III leverage ratio is the regulatory response to the build up by banks of what was seen as excessive levels of leverage before the financial crisis and the subsequent avalanche of deleveraging that led to a cycle of losses, falling bank capital and shrinking credit availability. The minimum 3% ratio set to be implemented in Europe is defined as the ratio of Tier 1 capital to on-balance sheet, derivative and other exposures.

Banks are required to report their ratios until the end of 2017, with the minimum level binding from January 2018. US authorities have proposed a supplementary ratio, hiking the minimum to 5%. The impact of the leverage ratio is simple: banks must either raise more capital or deleverage, and most have chosen the latter, reducing inventories sharply.

Investor enthusiasm

Somewhat ironically, banks' reduced appetite for corporate bonds comes at a time when investor demand could hardly be more enthusiastic. In the European market place some €8.35bn flowed into high-yield funds in 2013, according to JPMorgan, or some 22.7% of assets under management, with only one month in the past 12 seeing a net withdrawal of funds.

Demand for corporate bonds reflects improving economic fundamentals, strong corporate balance sheets and an environment in which mega-mergers and debt-financed expansion have taken a back seat to consolidation, cost cutting and productivity gains. For bond investors who care more about a company’s ability to pay back the money they have borrowed than their ability to increase returns, those kinds of strategies are intensely reassuring.

Investor demand has been reflected in declining yield spreads, with US high-yield bonds returning about 7% in 2013 (despite rising underlying rates) and 14% in 2012, according to Morgan Stanley. European high-yield markets also returned about 7% last year.

With demand peaking, some fund managers have found that the pressure to compete for limited supply is too much of a challenge and one large UK fund manager was reported in 2012 to have warned investors from investing in its corporate bond funds, amid concern that liquidity could dry up. The fund manager later denied the reports. At about the same time, the UK Financial Conduct Authority (FCA) wrote to fund managers asking for a review of liquidity and in particular the funds’ ability to meet redemption demands. The concern was that should some event lead to a rush for the exit, there may not be enough buyers to meet demand.

"Concerns have been raised with us that market liquidity has the potential to be impacted further as a result of the implementation of future global regulations,” the FCA said in its letter. “The market for these funds has been strong in recent years, and we wish to understand the extent to which a reversal of this trend could create risks for investors.”

One of the challenges facing investors is that companies are borrowing less relative to redemptions. Last year was the fourth consecutive 12-month period in which high-grade credit in Europe saw negative net issuance, with redemptions outstripping new supply. That theme is expected to continue in 2014 with some €255bn of redemptions from banks and companies pouring money back into the pockets of fund managers. JPMorgan forecasts net issuance of €50bn for the current year, with banks borrowing about €125bn less than they pay out in redemptions. 

In Europe in 2014 up to February 5, there have been 78 investment-grade corporate deals worth about $57bn. That compares with 977 deals worth $457bn for the whole of last year, according to data provider Dealogic.

Primary market

The importance of the primary market to corporate bond investors is reflected in the demand for new issues, which has routinely been between three and five times the amount of money borrowed in recent months. A typical case was a $5.4bn multicurrency deal in early February from Verizon Communications, helping to fund its buyout of its wireless joint venture with Vodafone. According to sources close to the deal, the sale attracted more than €20bn of orders.

“The level of demand for the deal was enormous,” says Luke Hickmore, an Edinburgh-based fund manager at Scottish Widows Investment Partnership. “Strong appetite in the primary [market] has been a consistent theme because if you want to get a $100m piece, that is the only place you are going to be able to find it.”

Still, the liquidity issues in the secondary bond market should not be overstated, says Mr Hickmore, and often the problem is lack of consistency, rather than a complete absence of opportunities, and higher cost. “It ebbs and flows from day to day, which means as a fund manager you can manage your funds around the edge. However, you will pay more because bid-ask spreads are much wider than they were a few years ago. That means that the rationale for switching from one idea to another has to be more compelling.”

Average European bid-offer spreads have in fact declined recently from 0.6% of par for investment-grade trades in February 2013 to 0.4% in February 2014, according to the MarketAxess European Bid-Ask Spread Index, but are still wider than in the US.

“The market is more opaque in Europe in terms of pre- and post-trade price transparency, and the market is more fragmented in Europe across issues and currencies,” says Alex Sedgwick, head of research at MarketAxess. “The recent improvement in bid-ask spreads is primarily a function of improving credit quality, rather than better liquidity.”


Mr Hickmore adds that the biggest liquidity problems faced by managers arise when they wish to make strategic changes to their funds. “The larger challenge is where there is a change in the macro-environment and you want to redesign the structure of the fund or the shape of your maturity profile. That needs bigger trades and more trading, and that can be difficult to do and take longer to execute,” he says.

Derivatives solution

One alternative for investors not able to find liquidity in the cash bonds market is to look to replicate credit exposures through derivatives, and in particular credit default swaps, where larger ticket sizes are available. However, this approach is not without its own challenges and banks are also reducing activity in the credit default swap space, particularly in single names (as opposed to index products).

On the Markit iTraxx indices of European credit default swaps, trading volumes have risen recently, with a JPMorgan index based at 100 in June 2013 rising to about 160 by the end of 2013. The index reading for single names on the other hand has stayed at about 100. JPMorgan explains the divergence on the basis of investor demand, with the importance of macro concerns over the European economy driving investors to broad exposures, rather than the idiosyncratic risks associated with one company.

However, many in the markets believe dealer willingness to provide liquidity in the single-name space has also declined. “Bank commitment to capital markets is lower, so they are not naturally hedging as much in the single-name space,” says Mr Hickmore.

In any event, the use of credit default swaps is no panacea. With the instruments mandated to be electronically traded and cleared through central counterparties, margin demands will place additional pressure on fund managers, requiring them to hold more cash or liquid securities such as government bonds.

“Certainly investors are looking to get more synthetic exposure to credit, because it is much easier to sell and to get back in if the market comes back again,” says Olivia Frieser, a London-based credit strategist at BNP Paribas. “But [credit default swaps are] not a simple solution and with the leverage ratio coming in, we may see liquidity under pressure in that market as well.”

Hard line

With a mind to what one banker called the UK financial services regulatory body Prudential Regulation Authority’s “hard line” on the leverage ratio, Lloyds and Barclays have announced they will reduce liquid assets, derivatives and repurchase agreements, or repos. “Obviously if you are cutting overall exposures then it is not going to help the product,” the banker says.

One part of bank business on which thinner resources of bonds will have a direct impact is in the repo space, in which banks either lend out bonds to investors looking to take short positions or provide financing on the basis of bonds taken as collateral. Repo rates have been grinding tighter in the recent period as buy-side firms look to use their stores of bonds to get access to leverage (a response to tightening market spreads).

“There is a lot of money chasing returns and one way to get those is to lever up, so the demand for repo is there and banks are responding," says Matt Lindsay, London operations manager at Blue Mountain Capital. “We are definitely seeing more appetite to print deals.”

The key to success in repos is to retain a large client base as that gives bank repo desks the ability to source bonds that are in demand. On that basis, banks with a lot of prime brokerage business are in a better position than their rivals. For example, in Europe that puts Credit Suisse ahead of JPMorgan.

“Banks that have a strong prime brokerage business will be much better placed on the short side because they have access to bonds,” says Mr Lindsay. “Those without the prime brokerage offering will need to go to interdealer brokers to source bonds, which does not work as well. Ultimately it is the banks with the inventory that win in the repo space.”

Trading alternatives

Given that the impacts of regulation are unlikely to go away anytime soon, corporate bond market participants have started to look for alternative ways to trade corporate bonds. Lloyds, for example, has moved away from the one-stop-shop model to focus on its most active market segment.

“We have a mission to become more specialised, working with our clients in the UK market and encouraging issuers to build out their curves and develop standard issuance patterns to encourage high levels of liquidity,” says Juan Blasco, head of credit products at Lloyds Bank. “It is also important that the industry comes together – the buy side, sell side and issuers – to try to find a solution. At the moment, for example, there are numerous bond-trading platforms. There probably needs to be consolidation in that space”

Société Générale, meanwhile, plans to take advantage of the withdrawal of some of its rivals from bond-trading to beef up its offering, with plans to add 150 staff in Asia and the US, according to the Financial Times.

Different solutions

As banks manoeuvre for position, the recent period has been characterised by the launch of an array of trading venues, as exchanges, banks and buy-side initiatives look to attract liquidity to their own solutions. At the end of 2013, some of the largest US banks tentatively agreed to create an electronic trading venue aimed at improving liquidity in the $9000bn US corporate bond market. Five major banks said they would help fund the new venue, working with platform provider Tradeweb.

In another initiative, the dominant US platform MarketAxess teamed up with BlackRock, after the asset manager failed to get sufficient support for its Aladdin corporate bond platform, launched with the intention of encouraging buy-side firms to trade among themselves. 

Elsewhere, UBS's Price Improvement Network, or PIN, offered multilateral bond-trading backed by the UBS balance sheet, but floundered because banks were unwilling to support a rival initiative. Goldman Sachs in 2012 launched twice-weekly auctions on its GSessions platform with a view to creating flashpoints of liquidity, but that also has failed to make much of an impression and the bank in September said it would restructure the offering. The Financial Times reported on February 18 that the platform’s development had been put on hold.

“Over the next three years you are going to see a new bond-trading platform launch every month,” says Mr Ponzo of GreySpark. “Across the industry people are experimenting with ways to find hidden liquidity and provide a nexus for buyers and sellers, but right now nobody has the silver bullet. In a world where you have a mosaic of options, market participants are going to have to learn to use the whole spectrum of trading platforms at their disposal to achieve their aims.”

While the platform route may offer some solace to liquidity-hungry investors, an alternative approach is emerging that may in the long run offer a smarter way for banks to source liquidity for their customers. Algorithms are being developed by the likes of start-up Algomi (run by Stu Taylor, formerly global head of matched trading in fixed income at UBS) that allow banks to run a marketplace based on the vast amount of information that flows across trading floors.

“Banks are adopting broking, not risk-taking strategies, with more than 60% of volume now estimated as wash-through,” says Mr Taylor. “The problem we saw was that to be a good broker requires not only centralised information, but more importantly immediate and global coordination that allows individual salespeople to quickly navigate their own firm’s distribution capability.”

Algomi’s solution runs alongside internal bank data sources, including voice inquiries that account for 75% of credit volume but are never shown on electronic venues.

The intelligent use of data to improve communication between participants may not itself lead to higher levels of liquidity, but the idea has attracted interest and Bloomberg is among those with a similar offering in its electronic Trade Order Management Solution. In a world of empty shelves, it is likely to be the cleverest birds that catch the worm.

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