This is a contributed article from Andrew Howieson, an advisor to FactEntry.
Corporate bond markets are inherently illiquid
There is now wide recognition that corporate debt markets lack sufficient liquidity to meet investor trading requirements. Blackrock’s September 2014 paper Corporate Bond Market Structure: The Time for Reform is Now described the trading market structure as “broken”. The withdrawal of dealer capital, driven by Basel III and Dodd-Frank regulation (leading to a reduction in corporate bond inventory from $250 mm to $60 mm in 2014) is broadly cited as the cause of dwindling liquidity. Market followers with longer memories may recall that buy-side concern over market liquidity and transaction costs pre-dates Basel III and was the driver of a generally brief but extensive flourishing of electronic trading “solutions” around 2000. It is not unreasonable to suggest the corporate bond markets are inherently illiquid and were only made partially and temporarily liquid through the application of dealer capital, at a price.
Trading systems alone cannot solve the liquidity issue
In the current liquidity drought, solutions have again focused primarily on the execution space with a wave of public order book systems (remember Cassiopeia?), followed by a range of negotiation and auction systems, some in a “dark pool” format. Already there is speculation on the number of trading systems likely to survive and reports of early casualties. A lesson from the previous flourishing of trading systems is that a well-designed system can optimise available liquidity but in itself does not create liquidity.
Creation of liquidity requires a more fundamental re-think of market practice, recognition that bonds cannot be traded in the same way as equities and an awareness of the benefits dealer intervention brings to the market beyond application of capital.
There is a fundamental structural problem –the “thousands of bonds” issue
The “elephant in the room” is the sheer scale of the corporate bond markets; where equity markets comprise hundreds of stocks, corporate debt markets comprise thousands of bonds, many with similar characteristics. A disconnect exists between the investment process and the trading process for corporate bonds. From an investment perspective a range of bonds may satisfy a portfolio requirement but trading is a serial process entailing bond-by-bond price discovery and potential information leakage. Further, ETFs and other index-linked investment vehicles focus on a limited range of benchmark bonds, with pricing implications for benchmark bonds and liquidity implications for the broader marketplace.
The opportunity is to move from trading on a serial to a portfolio basis where efficient identification of comparable bonds is critical
The first step toward a fundamental improvement in market liquidity requires an improved linkage between the investment and trading processes, with full identification of comparable bonds (or potential alternative trades). A consistent analysis of comparable bonds, intelligently applied, has the potential to improve liquidity in all trading formats including traditional dealer to client formats.
FactEntry, a specialist provider of fixed income data is developing Comparable Bonds Benchmark (CBB) to facilitate consistent and efficient identification of comparable bonds. CBB allows users to set their own comparable criteria—credit quality, sector, duration, yield and other key criteria are available, and to identify comparable bonds at the index, ETF, portfolio or individual bond levels. FactEntry will work with both buy-side and sell-side institutions to finalise the format of CBB, which is available through www.comparebond.com.
Efficient identification of comparable bonds provides a platform for an approach to trading which is better aligned with the investment process, facilitating assessment of a full range of trading options. Improved recognition of alternative trading options can significantly enhance liquidity in the current trading structure including the traditional RFQ environment, but that is not the end of the story. Market awareness of the scope of comparable bonds can be the driver of a demand for order types able to express a range of (conditional) trading interests and trading systems able to effectively match complex orders… all beginning with efficient identification of comparable bonds.