33 Autumn 2014

Ask any corporate bond trader what keeps them up at night, and the issue of liquidity will be lingering somewhere in their nocturnal fears. As the US winds down its quantitative easing programme, and the

market prepares for a rise in interest rates, there is still no single answer to the question of how a sell off will be managed given the reduced role of banks.

Corporate bond inventories held by US primary dealers have fallen 80% since their $250bn peak in 2007, according to the Federal Reserve Bank of New York. Meanwhile companies are on a borrowing spree, with the amount of corporate debt outstanding rising to $9.6trn at the end of 2013, compared with $6.4trn at the end of 2008, according to the Securities Industry and Financial Markets Association.

As bank inventories have declined, the biggest managers of bond funds have mushroomed. Pimco, Vanguard and Fidelity Investments between them

LIQUIDITY VACUUMA dramatic imbalance in the corporate bond market is giving market participants sleepless nights. David Rothnie reports.

BOND TRADING

BOND TRADING

34 Autumn 2014

manage 39% of all mutual fund-owned taxable bonds today, up from 18% in 1997, according to Morningstar Inc. data.

The bond market has caught the attention of the US Securities and Exchange Commission, which in June proposed regulations designed to make it cheaper and more efficient for investors to buy and sell bonds, such as increased disclosures on fees and more transparency on pricing, a move which the regulator hopes will encourage non-banks to provide more liquidity.

Basel IIIThe liquidity trap has arisen because of a combination of factors, such as new Basel III capital and liquidity

rules, which have driven up the cost of dealing, as banks must hold more capital against almost all assets and particularly against low-rated corporate bonds. Meanwhile restrictions on proprietary trading instigated by the Volcker rule have also reduced inventories.

In the meantime on the buyside, investors, who have become nervous about their ability to exit positions quickly in the event of a rate rise, have adopted more passive trading strategies such as exchange traded funds (ETFs), resulting in increased concentrations in a smaller number of Isins. Analysts say that in a market of 50,000 Isins or Cusips, trading is concentrated in fewer than 1,000 issues. Likewise,

Regulation has been a clear driver in reducing liquidity and driving up the cost of trading.

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dealer inventories have become concentrated around better known, well traded names, at the expense of less liquid or ‘off-the-run’ credits.

In addition, while liquidity has plummeted, investors have continued to pour billions of dollars into corporate bond funds, which have been an attractive asset class to invest in because they offer extra yield and relative safety in a low rate environment where it is difficult to generate alpha. In the past five years, holdings of bond mutual funds and ETFs in the US have doubled to around $900bn. The huge inflows from retail investors pose a particular danger because mutual funds and ETFs have to sell securities as soon as customers start to withdraw cash.

OutflowsIn August 2014, high yield bond funds suffered around $19bn of outflows within 24 business days as retail investors led a flight from higher risk assets. But the sell off, though significant, has so far failed to meet the market’s worst fears.

“We are seeing record outflows from high yield, but it doesn’t feel like a disorderly sell off. That’s partly because it’s isolated to high yield and partly because people are finding more creative ways of maintaining liquidity,” said Brad Rogoff, global cohead of credit strategy at Barclays in New York.

“A lot of retail funds have used Markit’s CDX index as a liquid way of still being invested. Also, what’s changed is the definition of a liquid bond if you want to raise cash. A decade ago, that might be a 10-year BB bond or in investment grade an ‘on-the-run’ bond. Short duration bonds are becoming a cash substitute,” he noted.

Many fear the consequences would be much more grave in the event of a broader market sell off involving institutional as well as retail investors, and many point to the ‘taper tantrum’ in May 2013, when former Fed chief Ben Bernanke first raised the prospect of reducing the US government’s asset buying programme, as a test case for the new world order of lower corporate bond liquidity.

The result was a dramatic widening in credit spreads in high yield and investment grade credit, resulting in heavy losses for some investors. Fortunately, the sell off was relatively brief, but market participants have contrasting explanations. Some argue that bond market Armageddon was averted because Bernanke appeared to wrestle back control of the yield curve by promising that the Fed would continue to support the market. Others say that while the spike in volatility was exacerbated by the absence of relative value traders and the trading desks of big investment banks failing to step in to buy the market, its damage was limited by market dynamics.

“In the investment grade market, I worry about a disorderly sell off over a two to three month period, but anything longer than that I don’t because insurance companies represent half of the market and they will buy at higher yields,” Rogoff said.

Change in mentalityThe notion of a short, sharp sell off reflects a change in trading behaviour that has come about because of the transfer of balance sheets from the sellside to the buyside.

“There is a real change in mentality underway,” says Rob Vandenassam, head of investment grade at Pinebridge Investments in New York. “Whereas in the old days, broker dealers would be willing buyers, looking to flip a bond, buyside investors take a more longterm view, and that increases volatility, as opposed to the sellside which is more flow based.

“Under the new buyside mentality, not as many people will be willing to bid and that’s what we saw during the taper tantrum - it wasn’t that people were selling, but that they weren’t buying,” he says.

If the liquidity trap in the corporate bond market is

$250bn Total corporate bond inventories held by US primary dealers have fallen 70% since their peak in 2007 of nearly $250bn.

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nothing new and has been a slow train coming since the crisis of 2008, then it is perhaps surprising that the industry is yet to find a solution. Partly, this is because it has not had to. Central bank support has maintained a bond bull market and convinced investors that the US Federal Reserve and the European Central Bank will continue to stand behind the markets, a conviction that endures. Then there is the differing pace at which regulations are being adopted. While European banks have been early adopters of Basel III reforms, the US dealer

community has come later to the party. There is debate in the industry over whether the

downturn in the fixed income markets is cyclical or secular, creating a bifurcation in banks’ strategies towards the asset class. While bond behemoths like Barclays have reduced the size of their secondary bond operations, rival Deutsche Bank remains committed to the model, believing that profitability and trading volume in the asset class will snap back as interest rates rise.

“Regulation has been a clear driver in reducing liquidity and driving up the cost of trading, but there is also the reality that in a low interest rate environment it is not in dealers’ commercial interests to warehouse risk,” said Dominic Holland, global head of e-credit sales at Deutsche Bank in London.

“With companies scrambling to refinance at a highly attractive all-in cost of financing, the new issue market has been booming and that has diverted investor dollars from the secondary to the primary

market. There’s a strong argument that once interest rates rise, the result will be a much more vibrant secondary market.”

Meanwhile, there is something akin to a technology arms race as both the sellside and buyside search for new ways of trading bonds that will boost efficiency, reduce the cost of trading and solve the liquidity problem. The quest is to find new ways of doing business that do not use the long-standing request-for-quote model that makes the buyside reliant on the sellside to make prices.

Inspiration from equity The innovations borrow heavily from the equity markets, which moved from a principal to an agency trading model several years ago with the advent of electronic trading. Bond market participants on both the buyside and sellside have launched several initiatives to encourage investors that own the vast majority of bond inventory to submit orders on exchange-like platforms and provide liquidity through central limit order books - as happens in the equity markets. Meanwhile, banks have set up crossing networks to match client orders.

UBS was the first investment bank to set up such a network with the launch of its price improvement network in 2010, followed by rivals such as Goldman Sachs and Morgan Stanley. None of these platforms have significantly changed the landscape, and several have been quietly shelved.

Another concern is that the emergence of multiple platforms threatens to fragment rather than boost liquidity, and the industry cannot agree on whether it needs a revolution or evolution.

“Electronic trading has helped but if we have a bad day certain things go no bid. The major broker dealers remain the best source of liquidity and they are able to ‘work an order’. That is why voice will never be over-taken by electronic. The risk with electronic systems is that you show the world what you’re doing and it frightens the world,” Vandenassam said.

Buyside-to-buyside crossingIn 2012, BlackRock seized the initiative with the launch of its Aladdin Trading Network, designed to allow other participants on the buyside to cross buy and sell orders between themselves. Ultimately, the initiative failed and was spun off to MarketAxess in May 2013. The reasons are manifold; first BlackRock did not manage to sign up a sufficient number of asset managers to build a critical mass. Also, asset managers often faced the same way on a trade, and were unable or unwilling to take on the role of market makers.

Electronic trading has helped but if we have a bad day certain things go no bid.

Worlds apart Stocks Corporate bonds

Total market value $17trn $8.1trnEstimated listings 6,500 40,000Average daily trades 25.2m 40,280Average daily volumes $112.9bn $17.9bn

Source: SIFMA, MarketAxess, TABB Group

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The dash for innovation has led to fragmentation - an estimated 32 bond platforms have sprung up. But the real problem that Aladdin showed was that dealer activity is still necessary to grease the wheels of liquidity.

In July, Tradeweb announced it is beta testing a US corporate bond dealing platform on which dealers will be required to stream a minimum number of price quotes. Tradeweb says investors will have a 95% certainty of getting their orders filled.

Culture shockCritics say the Tradeweb system will be a culture shock in the US, where around 14% of the corporate bond market is traded electronically, compared with around 45% in Europe, according to industry estimates.

Tradeweb’s arrival on the scene diverted attention away from other emerging solutions, such as the Oasis project led by Deutsche Bank. The aim of Oasis is to create a new protocol for motivated buyers and sellers, but which provides investors with anonymity to protect them against information leakage as to their intentions before posting trades in an open market.

Deutsche Bank’s Holland, who has been a driving force behind Oasis, says the answer lies in improving information, rather than a radical new model.

“There is a real consensus emerging that a protocol which brings together motivated buyers and sellers is likely to be the most effective solution in creating greater market efficiency,” he says.

“To do that, it’s about improving the quality of information to help clients find the other side of the trade. E-communication is about better connectivity, it’s not some revolutionary new model to be scared of. It’s about finding motivated buyers and sellers and finding pools of liquidity in discrete markets and cutting out the pre trade noise.”

One solution that purports to do just that is Algomi, led by Stuart Taylor, who previously launched UBS Pin-FI. Algomi works on the basis that in contrast to equities, corporate bonds are an inherently illiquid asset class unsuited to central limit order books or crossing networks. It aims to capture information on where liquidity is located among the bank’s customers so that the dealer can act on that information and work more effectively than a system that streams prices in the hope of getting a phone call.

Apocalypse now The recent high yield sell off doesn’t feel like the start of an Apocalypse to most market professionals, but then the market never anticipates the biggest crises.

“A year ago, people were very concerned that the exit door was getting smaller, but investors are still buying credit at these levels. It’s clear that there’s some froth in the market, and that retail is an overweight component, but I haven’t been able to find investors looking to exit or who are substantially overweight,” Holland added.

Meanwhile, it’s not just pre trade noise that is threatening stability. Banks, technology providers and

investors are engaged in an ongoing debate about how to solve the liquidity challenge. And regulators are coming up with their own solutions. In July, Fed chair Janet Yellen said in her biannual testimony to Congress that she sees no evidence of systemic risk.

“Electronic platforms can boost efficiency but can they be providers of last resort liquidity? No. Capital is the provider of liquidity,” Rogoff said.

“The only solution to the drop in liquidity in the corporate bond markets is that more money is managed with different lockup provisions and there are more sources of longer term capital.”

Until interest rates start to rise significantly the theories on the extent of the liquidity crisis are likely to remain untested. Many real money accounts are certain to rush for the exit when there is a reversal in fortunes. Who takes the other side of that trade will be the big question.

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Retail owns 37% of US credit

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1.5% Credit market size Dealers’ est. holdings

$19bn In August 2014, high yield bond funds suffered around $19bn of outflows over 24 business days.

US credit by investor type

Market grows but dealers pull back

Source: RBS, Federal Reserve Bank of New York

Source: RBS, SIFMA, MarketAxess, Federal Reserve Bank of New York