Fixed Income Outlook: Expanded Access to Liquidity, and Opportunities Amidst Trade Tension

To get into the weeds a bit on the credit outlook, we asked Joseph Kalish, Chief Global Macro Strategist at Ned Davis Research Group (NDR), and NDR’s Veneta Dimitrova, Senior U.S. Economist, to tell us what’s currently on their radar screen.

Here’s a summary of what Kalish and Dimitrova have included in their H2 outlook as of June 6, 2019*:

• We reaffirm our marketweight/neutral outlook on corporate credit. Overall, the data is mixed, which argues for a continued allocation to credit, but not an aggressive or defensive posture at this time. We continue to favor the middle of the credit spectrum, or BBB and BB. BBBs represent half of IG corporates in U.S. and Europe.
• Investment grade and high yield spreads remain historically tight. Flows into high yield have dried up, but continue to be seen in investment grade. Spreads per unit of duration remain a little rich for investment grade, but close to their historical averages for high yield. Investment grade yields are falling more than spreads are widening. The high yield cash/assets ratio is no longer bearish. Liquidity, however, has improved.
• Economic fundamentals are still favorable. The economy is clearly slowing, based on a slew of our favorite leading indicators, including the Credit Managers’ Index, the ISM indexes, the Composite Leading Index, the OECD Composite Leading Indicators, and the state leading indicators. Nevertheless, our Credit Conditions Index remains favorable for economic growth, and there is little danger of recession.
• Technicals are mixed. Breadth and momentum are supportive for investment grade credit, but high yield has weakened. Similarly, high yield relative strength has softened, but has not yet broken down. Cross-asset volatility is no worse than neutral. Low volatility is conducive for carry
• Longer-term, we remain concerned about the deterioration of corporate credit quality and the lack of trading liquidity. But we aren’t overly concerned today, as most companies don’t have problems making their interest payments.
• We prefer loans to high yield bonds on valuation and relative performance. Loans are modestly cheap compared to high yield, which have seen relative performance roll over.

*See important information and disclaimers below.

At the II Fixed Income Forum in Washington, D.C., in April, asset owners from pension funds and asset managers participated in real-time polling regarding the outlook for fixed income. Here is the top response to a question on the challenges faced by their organizations today.

Greater adoption of electronic trading has driven the average trade size down, and alongside that, liquidity in the bond market has evolved. The result? Expanded access to liquidity – especially that available in the retail market has become increasingly relevant to institutional traders. To cater to this demand, Tradeweb has integrated once highly discrete, liquidity pools from the firm’s institutional and Tradeweb Direct platforms. II spoke with Tradeweb’s Amanda Meatto (above right), Head of Sales and Relationship Management at Tradeweb Direct, and Iseult Conlin (above left), U.S. Institutional Credit Product Manager, to hear more about how they innovate to open up access for clients to more than $6bn of actionable liquidity per side in more than 6,000 CUSIPs.

Is it more significant that institutional traders can now access streaming liquidity, or that they can do so without interrupting their usual workflow?

Iseult Conlin: It’s both. For most institutional clients, this is the first time they are accessing live streaming retail liquidity – that is, continuous firm quotes that are immediately actionable – as we have historically operated the two marketplaces on separate platforms. There are a lot of institutional buy-side participants that still don’t know this liquidity exists, and even those who previously knew, tended to ignore it because they couldn’t access it easily from their screens. That was compounded by the different use of execution protocols within these market segments, which made it all the more difficult for large institutional buy side firms with RFQ workflows to access streaming liquidity elsewhere. Market convention has also played a part: the retail business typically trades off price, and the institutional buy-side is more spread-based. At Tradeweb, we have integrated $10bn of additional liquidity without altering either participant’s normal workflow. That’s really significant improvement for these trading communities.

Amanda Meatto: I agree. The one thing we hear consistently from clients is that they don’t want to have to log in to lots of different platforms. We totally understand – simpler is better – and especially when workflow, behavior and compliance procedures are already so ingrained. That’s why we made a very deliberate choice to deliver a solution for traders that expands the picture but doesn’t alter the screen.

And why is Tradeweb Direct uniquely positioned to provide this capability?

Meatto: Well 80% of retail corporate trades are actually live streaming markets so it makes sense to offer it to institutional accounts as well. On average daily, Tradeweb Direct offers 16,000 live markets on quotes of $250K and above, and over 5,000 live markets on those over $500K. We didn’t really need to persuade the institutional buy-side on how useful that was: the trade sizes are very similar to existing volume on the platforms they use each day, and so it was really a no-brainer for them.

Are there deal size thresholds for the retail liquidity in this integrated liquidity pool?

Meatto: From the Tradeweb Direct side, we now stream all markets up to $1 million onto the institutional platform. For a trade larger than that, you’d typically expect to see a response via RFQ anyway. On the taker side, the liquidity initiator is looking to see how many more additional quotes they’ll get, and they’re seeing anywhere from a 40 – 50% increase of respondents.

Is the integrated liquidity pool only for investment grade corporates?

Conlin: We’re talking about everything that falls under the umbrella of U.S. Credit – investment grade credit, high-yield, even emerging markets. For anything under $250,000 notional, Tradeweb Direct markets account for more than 18% of the anonymous trades on the institutional platform. The trade sizes might be smaller, but the huge positives of competitive pricing are there for IG, HY and EM.

Is there interest in the integrated liquidity pool outside of the U.S.?

Conlin: Absolutely, the European market structure tends to be a price-based market, and so it leans toward streams and click-to-trade. This means our current efforts really gel with what they’re used to seeing already, and we’ve got Europe-based clients, who want to use the solution. We’ve already seen them take some of their U.S. dollar credit trading in particular and bring that over, because they are accessing liquidity that they couldn’t otherwise. That has a network effect: diverse liquidity begets more diverse liquidity.

Meatto: We’re focused on making this solution as intuitive and accessible as possible. It’s obviously less straightforward to integrate counterparties in different countries due to regulatory and compliance variations, but our size and scale across global markets really helps when it comes to addressing these pain points. We’re focused on providing a single point of execution for participants, whatever the firm, and wherever they trade.

Technology’s effect on fixed income is continually evolving. Here is more recommended reading and viewing to help you keep up with the latest trends.

“Electronification” and the Technology Revolution in Corporate Bond Trading

Portfolio Traders Turn to Tech: A New Generation of Strategies

The Buy Side’s Big Leap of Sophistication in U.S. Credit

Reducing Trading Costs for U.S. Corporate Bonds

Intelligently Automating Trade Execution

At the II Fixed Income Forum in Washington, D.C., in April, asset owners from pension funds and asset managers participated in real-time polling regarding the outlook for fixed income. Here is what they are thinking about factor investing in fixed income.

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At the II Fixed Income Forum in Washington, D.C., in April, asset owners from pension funds and asset managers participated in real-time polling regarding the outlook for fixed income. Here are the responses to a question regarding what they feel to be the top risks in credit.

“The volatility on trade is here to stay,” says Matt Toms, Chief Investment Officer, Fixed Income, at Voya. But not for the reasons you might think based on the headlines. In this interview with II, Toms talks about what fixed income investors should be watchful of as part two of 2019 gets underway.

From a macro perspective, what should fixed-income investors keep an eye on in the second half of 2019?

Trade uncertainty with China is unlikely to subside any time soon, regardless of the effects of tariffs, because the trade misalignment is really about intellectual property and technology transfers. Working through that is going to take time. The volatility on trade is here to stay. We might see short-term abatement or stepping back when the meeting happens between Trump and Xi, but it would be a mistake to believe that it is gone for good. It doesn’t look like there is a gone-for-good scenario given the intellectual property and technology issues that are on the table. That ongoing volatility is important because it’s a key determinant of investors’ perception of growth outside the U.S. Despite U.S. growth looking otherwise resilient, the markets are taking their cues from Europe and broader emerging markets.

What about inflation? That seems to be a topic flying under the radar at the moment.

That’s the second most important thing to watch, but no one is talking about inflation right now because no on fears it at all right now. We rallied the two-year Treasury inside of 2 percent. Cuts are baked in for the Fed, and within the market’s mindset were not so convinced cuts are going to happen. We need to have the continued sanguine view of inflation by the markets, otherwise you get into a more difficult situation and the Fed doesn’t have the same flexibility. Inflation readings are currently picking up a little bit, but are likely to roll over with oil and growth in the second half of the year – in fact, it’s really critical that they do. We’d be concerned if they don’t. As a firm, we caution investors to watch those inflation readings and not assume it is fully dead.

What’s behind the absolute lack of fear of inflation?

Partly because it’s hard to forecast with any effectiveness. The Fed doesn’t have a good model, investors don’t have a good model, and it has been tame so everyone believes it will continue to be tame. The only more difficult thing to forecast is productivity, and the reason people feel good about inflation is because productivity has been strong. We are in that camp as well, but if productivity comes down, inflation could move higher.

It’s commonly posited that we are near the end, or the beginning of the end, of a growth cycle. Are we?

The beginning of this growth cycle really didn’t occur until about four years after the financial crisis. There really wasn’t credit expansion until 2012-2013. So, if you believe credit expansion can only happen for six or seven years historically, then we’re getting to that point. But, if you get that start date correct, then the current cycle isn’t as expanded as some say it is.

What is probably more important is that cycles don’t die of old age. Typically, an imbalance or an event causes a rolling over of growth into recession. In that context, when we survey the horizon we see supply-side constraint and not a lot of spare capacity. Unemployment is quite low at the moment, so there isn’t an abundance of workers to draw back into the economy. That said, we don’t see an imbalance in the banking industry, and we don’t see an imbalance in the consumer balance sheet. In fact, it’s quite the opposite – banks and consumers are in fantastic shape, and U.S. savings continue to increase. We don’t see an obvious imbalance or event in this context occurring in the U.S., so if it happens it’s likely to occur outside the U.S., which takes us back to why the markets are so transfixed on international trade.

One other thing that is helping to extend this cycle that people still clearly remember the pain the financial crisis caused in all elements of society, and they fear it might happen again. That type of fear leads to caution, and caution leads to stability. It’s that caution that stops this current cycle from getting too exuberant or overleveraged.

Speaking of the financial crisis, securitized credit is back in the fixed income limelight, but in a good way. Why is that important for institutional investors?

The growth of securitized credit we saw running up to the crisis was pushback from the fear of corporate debt from corporate blowups like Enron and WorldCom in the early 2000s. If you were an investor, at least with securitized credit you knew a mortgage, an auto loan, or a student was actually there, in a trust. That helped fuel the securitization frenzy, which was ultimately undermined by the assets being put into the trusts – not the structure of securitized credit itself.

We think the push away from securitization was much too strong, and there has been a lot of work done post-crisis with stricter retention and underwriting guidelines, and investors understanding that you need to understand and underwrite the quality of the assets within the securitized trust, and not just go by a rating. With those understandings, the securitization market has matured and evolved, and we believe it is a here to stay.

How does securitized credit compare and contrast with other forms of debt?

Securitization does offer alternative access to higher ratings – there is a AAA and AA tranche, and there aren’t that many AAA and AA instruments left in the world, particularly with governments like the U.S. losing their AAA rating. The ability to have 30% or 40% of subordinated capital beneath you in these structures provides very high ratings and very low risk of default or loss. And in the high-end ratings for securitized credit there is very little rating migration. For regulated entities that is very useful, because you have less rating volatility to put into your capital model. Corporate bonds, for example, tend to migrate lower as a portfolio over time. That stability, or lack of downside, when you’re starting with AAA or AA is an underappreciated aspect of securitized credit. That’s not true if you are at an A rating or below, but it is certainly true at the top of the stack.

There’s also a good amount of floating rate assets available in securitized. That was much more attractive in a Fed hike cycle, but a lot of those splitting rate assets are still based off Libor which is at 250 today, compared to a 212 10-year. If you’re like floating rate exposure, securitization provides that alternative. There’s much less floating rate corporate debt available in the world.

And let’s not forget diversification. Securitized allows investors to diversify away from benchmarks and portfolios that are heavy with corporate bonds and to get more direct exposure to the U.S. consumer. There is an array of assets, from AAA agencies to non-agencies, CRTs and ABSs – credit cards, student loans, aircraft loans, solar rooftops. Consumer debt has been deleveraging post-crisis, while the corporate leverage base has been increasing.

Is there opportunity in the vast BBB corporate debt space?

Clearly, we preferred securitized, but yes, on an issuer by issuer basis, we think there are still opportunities in BBB corporate credit. There are management teams that now have stated goals – in some cases, compensation–related goals, to decrease in the amount of debt that they have incurred through recent acquisitions. That’s good news for bondholders, who typically don’t have that direct alignment with management, which generally is more equity oriented. The point is, market concern about BBB debt levels being elevated has started to cause management teams to address that issue, which is good news and likely lowers the systemic risk in that component of the market.

In recent years emerging market debt has been eyed as a potential source of growth. What are thoughts on EM debt looking forward?

We do think that structurally you’ll continue to see emerging markets providing opportunities. It’s a naturally higher rate of growth of debts, so there will be more market opportunities available for investors, and that’s good news. EM does tend to come with a bit more tail risk than in other sectors – a higher degree of volatility in EM than there is in Corporate or Securitized. Because you have two elements in EM that tend to spike up when tail risk increases: oil sensitivity and dollar funding sensitivity. Oil sensitivity tends to hurt at times in EM, and is typically correlated to the downturns in the equity market. Second, a lot of EM debt is printed in U.S. dollars, and when the dollar rallies in times of stress that can be a point of strain for EMs.

And what about China, specifically?

We have not yet moved to a place where we view China as a stand-alone allocation. It’s clear that China is a hybrid as it develops a market. Given the array of risk that comes with EM investments, we prefer to be very opportunistic in moving in and out of individual countries, as opposed to have a standing through the cycle allocation to any single one.

Discover more opportunities across the fixed income spectrum.

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