Fixed income trading in the era of liquidity shortages

With each passing month it becomes more difficult to transact without moving prices because of a shortage of market-making capital. One of the main causes of this shortage is the approaching full implementation of Basel III in 2019. Under this regulatory regime, banks are being required to hold greater amounts of capital to take trading positions on to their balance sheets, so they’re less willing to do so. Higher-yielding, higher-risk assets currently in demand by income-hungry investors are particularly expensive to hold under risk-adjusted capital requirements.

Regulatory efforts to improve market transparency, such as the second Markets in Financial Instruments Directive (MiFID II) in the EU and the Trade Reporting and Compliance Engine (TRACE) in the US, are not helping. We strongly support the goal of enhancing market transparency. However, having to report large trades too soon after the fact can make a dealer less willing to commit capital for market-making activities, out of concern that other participants’ knowledge of its position could impair its ability to efficiently hedge or liquidate the position.

Growing investor demand for more liquid deals to offset the impact of reduced secondary-market liquidity is stoking interest in new issues, especially larger ones. This is intensifying the skew of liquidity away from older to newer issues.

Using credit derivatives to cope with illiquidity in cash bonds

Credit-derivative indexes such as the CDX family of credit default swaps have consistently been the most liquid instruments in credit markets. However, many client mandates don’t allow trading in derivatives. Also, there can be meaningful tracking error between credit derivatives and a mandate’s benchmark index. But even though credit-derivative indexes aren’t perfect hedges, they can somewhat mitigate portfolio risk. Cash bonds carry rate risk, while CDX indexes, for instance, do not; they are weighted baskets of credit-default swap exposures that only capture credit spread.

Are electronic trading platforms the answer?

Our firm is engaging with vendors of several new and testing-phase electronic platforms to assess their potential. These include enquiry-based systems, where we send a request to buy or sell to dozens of counterparties, versus calling a handful of dealers; price-making platforms, where we set a desired bid or offer price and any party on the platform can try to meet it; and auctions, in which an operator alerts market participants daily of a small number of specific securities to be auctioned off, and potential buyers can submit bids.

Yet e-platforms have limitations as a comprehensive solution to the liquidity challenge. To be truly successful, an e-platform must be seen as an independent third party. That hasn’t happened yet. More importantly, a publicly listed company has a single common equity but can have many bond issues outstanding. Continuously matching buyers and sellers on all these issues would be challenging to automate. So e-platforms seem unlikely to achieve the market share in fixed income that they’ve gained in equity markets.

Standardising and consolidating new issuance as a way to improve market liquidity

Today there are roughly 25,000 investment-grade bonds trading in the US alone. If issuers could be incentivised to consolidate their maturities, a major issuer could cut, say, 300 bond issues down to 25; each time it wanted to borrow it would reopen an existing security instead of creating a brand-new one. This could help mitigate the 25,000-bond problem. However, tax and/or accounting implications for the issuer may be a hurdle.

Furthermore, corporate issuers will be hesitant to cede management of their financial flows to some preset schedule unless they are convinced that doing so will be of value to their organisation. Over the last few years, it’s been difficult to prove that issuers have been penalised by the market for issuing new bonds at their discretion and not according to a telegraphed plan. A more gradual approach may be to change rules to make it easier for companies to exchange older for newer securities.

The rise of exchange-traded funds (ETFs)

As the market share of fixed income assets held in ETFs and mutual funds promising daily liquidity rises, so does the potential pressure on market liquidity. Market movements and investment capital flows can become mutually reinforcing; sudden investor actions could spark a liquidity panic.

Many of our clients have amended their investment guidelines to be able to use bond ETFs. However, others haven’t because they regard ETFs as too much like equity securities, and hence exclude them from their fixed income mandates. ETF sponsors are developing products to overcome these hurdles.

What Wellington Management is doing

Our firm is taking steps to address the liquidity-challenged environment by:

•   Developing data systems that help us better understand our clients’ usage of dealer balance sheets. We are dedicating significant resources to building technology and reporting systems that quantify what each side gets out of the relationship and constructive, data-driven dialogues that can fortify it.

•   Using ETFs, derivative indexes, and other relatively liquid vehicles and instruments in client portfolios (as appropriate for a specific mandate and if eligible under its investment guidelines).

•  Actively engaging with established and start-up electronic trading platforms. A dedicated team of senior managers is focused on assessing and developing such platforms.

•  Leveraging a dedicated syndicate desk to participate in offerings of new bonds and loans across multiple sectors and asset classes, as part of striving to optimise outcomes for client portfolios in a highly competitive market.

•  Seeking out securities that we think are cheaply priced because of scarce liquidity, not poor fundamentals.

For more information contact Bob Sharma, head of EMEA Insurance, Wellington Management, BSSharma@wellington.com

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