By Kevin Rutter, CEO, AIQ Markets.
As any bond trader will tell you, when stress occurs in investment grade, it’s time to take notice. The New York Fed recently flagged a sharp increase in high-grade trading dysfunction during July.
The CDMI Index, a weekly composite measure that represents the health and functioning of primary and secondary corporate bond markets across volume, liquidity, and default-adjusted spreads reached a three year high.
Given investment grade credit is one of the deepest, most active markets in global finance, market participants should be aware that abnormal health of the market at this level will almost certainly have downstream effects.
The issue is, in part, a function of natural market forces. Accompanying broader macro uncertainty, the investment grade market has seen an explosion of issuance as tech hyper-scalers look to raise funds to finance the AI revolution. But as investors have become wary of this deluge of supply, the pricing of risk has become more nuanced, creating fissures between issuers and making single-bond analysis more critical.
The fragmentation challenge
The challenge of market dysfunction is particularly acute in the corporate bond market, which is already highly diversified with liquidity fractured across thousands of individually traded CUSIPs.
In addition, the pricing of some of these bonds is often found in disparate dealer platforms or private repositories. This means that, while technically available to trade, they remain invisible to most market participants until they materialize on a trader’s blotter.
As a result, desk traders often find themselves defaulting to a short list of more liquid names and index- or ETF- constituents because sifting through thousands of bonds to find value is simply too time-consuming. This trend can become even more pronounced during abnormal market periods.
Technological tools for discovery
Modern search technology has the potential to start chipping away at this challenge, harnessing the power of AI to enable powerful pattern recognition and discovery tools that can vastly improve the efficiency of the fixed income market professional.
Portfolio managers no longer have to piece together hundreds of data points across six screens – they can instead ask the database to identify patterns of interest to them and provide rebalancing suggestions based off “lookalikes” or rotations into other index and ETF constituents.
This represents a significant leap forward in terms of productivity, but it is important to recognize that better search and discovery do not make illiquid bonds liquid. Rather, making an asset visible brings buyers and sellers to the same table faster, helping desks cross trades that would have otherwise fallen through the cracks.
For the buy-side, this will eventually present an opportunity to diversify their investments beyond the most liquid segments of the market. By broadening their exposure to a wider set of issuers rather than simply chasing the largest names, fixed income desks can unlock alpha by taking advantage of both size and value opportunities at once.
The NY Fed warning serves as a much-needed wake-up call for market participants to reassess their approaches to the fixed income market. In an environment of growing market stress, fragmentation, and thin liquidity, it is no longer enough to simply amass a deep repository of market data. Instead, the most successful desks will be those that can leverage their data to identify the often-subtle inefficiencies that can be found in the cracks of the market.
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