Over the past couple of years, there have been many warnings about a looming crisis in the corporate bond market. Their dire tone stems from two key concerns. The first is the potential imbalance in demand and supply in the event that credit risk is repriced following a micro- or macroeconomic shock. The second is a far-reaching, more fundamental one: Is the market structure as it stands able to deliver enough readily available liquidity for institutional investors to keep the asset class healthy and viable over the long term?
For a long time, corporate bond liquidity — how easily securities can be traded without affecting their price — was managed largely by banks, which warehoused bond inventories and then sold to institutions. Now, seven years after the 2008 financial crisis, the banks have to keep higher levels of capital that can’t be tied up holding corporate bonds. With dwindling inventories, there needs to be a way to address liquidity issues that takes into account the lack of both dealer capital commitment and centralization.
Equities faced similar challenges 15 years ago. Liquidity was exposed to brokers on an as-needed basis, then filtered through to a market that was inefficient at aggregating it. This meant that only the most readily available liquidity — from the big names that were traded frequently — was easily accessible. The rest was either held by brokers who were unable to efficiently advertise or was held by institutional investors but locked up in their tightly controlled manual blotters. The solution devised for equities back then is exactly what the corporate bond market needs today, that is, a method of tapping into liquidity opportunities at the source: the large institutional investors that own the vast majority of corporate bond assets.
The corporate bond market is only now facing up this challenge because it has evolved more slowly than that for equities. The biggest innovation has been the request-for-quote protocol, which the majority of corporate bond–trading venues use today to make dealer-to-client communication more efficient. It’s a system that works well enough for small trades and frequently traded bonds, though does little for larger or more difficult to trade fixed income. As a consequence, it contributes to a concentration of trading volume. Some estimate that 90 percent of volume is accounted for by just 20 percent of investment-grade and high-yield corporate bonds.
We at Liquidnet did our own analysis of corporate bond investing by examining a selection of 44 corporate bond portfolios in the U.S. Using second-quarter 2015 market data, we found that, on average, 40 percent of bonds showed up in 60 percent of portfolios. This result indicates a larger liquidity opportunity than volume trends would have us believe. Trading opportunities appear to be concentrated in a relatively narrow range of bonds — perhaps because many of them are easy to trade — whereas a large percentage of bond issues are being left on the table. Clearly, there is more room to bolster bond-trading volume.
The market needs to implement five key conditions to better streamline trading and ensure that investors don’t miss out on opportunities. The first is that there needs to be a critical mass of asset managers, liquidity and appetites to trade. Without enough of the market actively participating, match rates would be suboptimal, and not much interest would be sparked.
Second, institutions should be able to engage and match directly with one another anonymously and in size while avoiding information leakage and minimizing price impact.
The third condition is connectivity into existing order management systems, which would allow for more seamless integration into a trader’s current workflow.
Fourth, we need a better aggregation of price data to help institutions meet their best-execution requirements and provide intelligent transaction cost analysis; both have been elusive in the corporate bond market but are becoming increasingly vital for large institutions as the regulatory environment evolves.
Fifth and last, the corporate bond–trading solution of the future has to be able to maintain the integrity of the system and the protection of its community of institutional traders by monitoring participant behavior, enforcing protocols and implementing sophisticated surveillance systems. Creating a trusted and secure environment, specifically for institutions to trade, is crucial to the success of corporate bond trading.
The corporate bond market is crying out for a solution that expands liquidity, trading volumes and market breadth. But this can only happen if industry participants commit to actually being a part of that solution.
Constantinos Antoniades is global head of fixed income at Liquidnet in New York.
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