Executive Summary

A decade on from the financial crisis, which triggered the bond-dealer balance sheet reduction, institutional corporate bond investors are finally feeling some liquidity relief.

Electronic trading over the past few years has eased the buy side’s ability to execute odd-lot orders.

Many of those same tools have now found their way into the block-trade ecosystem, with over three-quarters of corporate bond investors feeling it is easy or extremely easy to execute orders up to $5 million in size. This is a stark contrast to the sentiment only a year ago.

A decade on from the financial crisis, which triggered the bond-dealer balance sheet reduction, institutional corporate bond investors are finally feeling some liquidity relief. Electronic trading over the past few years has eased the buy side’s ability to execute odd-lot orders (those under $1 million in size). Many of those same tools have now found their way into the block-trade ecosystem, with over three-quarters of corporate bond investors feeling it is easy or extremely easy to execute orders up to $5 million in size. This is a stark contrast to the sentiment only a year ago, where that same metric was barely one-third.

Easy, however, is a relative term. What a bond trader defines as easy differs widely from a U.S. equity or spot-FX trader’s perception, for instance. So we should not conclude that bond market liquidity is starting to creep up to levels that resemble those of stocks in the S&P 500. Furthermore, trades over $5 million in size continue to prove difficult for investors to trade. While these large trades only make up 1% of the total orders in the market on a given day, they make up over 40% of the notional amount traded. As such, creating mechanisms to execute these orders more efficiently, while still limiting information leakage, remains a goal that the market must continue to chase.

Self-Service is Shaping Investor Behavior

Technology innovation plays a huge role in creating new opportunities for market participants to interact, but it will be the subsequent changes in behavior that truly generate liquidity. Case in point: More than half of corporate bond investors believe that all-to-all trading will be the biggest source of new liquidity in the coming years, up from 40% in 2016. New e-trading venues and protocols have undoubtedly made these interactions between asset managers possible. However, it is the actions of the market participants themselves—investors trading anonymously, acting as price makers, etc.—that have ultimately added liquidity.

Despite their endorsement of all-to-all trading, the buy side is also increasingly bullish on traditional bond dealers, hoping that they will put more capital to work under a more markets-friendly Washington. The dealers have had years to adapt to the new market structure, upgrading both people and technology to run the business leaner, while still providing top-tier service to profit-generating customers. Their technology story is partly about trading, but primarily about utilizing data more effectively. Improved communication of axes, for instance, is also seen as a potentially large new source of liquidity. Bloomberg, MarketAxess and Tradeweb, as well as Algomi and Neptune, all have viable solutions targeting that need.

Lastly, our research points to a growing belief that fixed-income ETFs are here to stay and are generally positive for the market. Among other use cases, bond investors frequently apply them for interim exposure when buying or selling a position, to trade baskets via the create-redeem process and as a derivatives replacement. Conversely, positive sentiment regarding nonbank liquidity providers has waned, although those firms play a big part in keeping the ETF market liquid—a paradox in buy-side thinking.

Liquidity driven by ETF market activity is surfacing in other ways. The market has learned how to trade portfolios of bonds when creating or redeeming ETFs. Today that concept has expanded, with dealers now willing and increasingly able to buy an entire basket of bonds from an asset manager for a single price, rather than simply as part of a create-redeem. Pricing the bonds in aggregate speeds up the price-discovery process on each individual security. One bond that is slightly overpriced can be offset by one that seems underpriced. This ultimately allows the entire basket to trade, even if those single orders might have failed on their own. Expect new solutions from the major trading venues in 2018.

Make Up Your Mind

Despite all the new technology—machine learning, artificial intelligence (AI), real-time analytics—gut feel still drives the market. Experience, at least as far as buy-side traders are concerned, still results in a better quality execution than one managed by robots. This could be changing, if we assume that today’s gut feel is largely influenced by the data now at the traders’ fingertips: historical data, visible liquidity in historic markets, aggregated axes, TCA, evaluated prices, and more. Perhaps an overly generous assumption, but, ultimately, this is the direction the market is heading.

For instance, one investor reported using AI in decision-making for 90% of their trades, leading to a 25% decrease in trading costs. Furthermore, as we enter what is likely the first bond bear market in four decades, the desk is staffed with traders who have never dealt with such a market environment. When even 25 years’ experience can’t help determine what might happen next, augmenting human intelligence with machines not only helps, but is necessary.

Although dealer relationships still matter a great deal, corporate bond investors report that calls with dealers influence their trading decisions less often than investors trading government bonds, interest-rate swaps and credit-default swaps (CDS). In fact, these categories trade electronically three times as often as corporate bonds do. Our conclusion: While only one-fifth of corporate bond volume trades electronically, technology is starting to play an even greater role than it does in markets with higher levels of e-trading. Even when electronic execution is difficult or unrealistic due to such limited liquidity, the buy side is still utilizing the best technology, data and market color they can get their hands on to ensure they make the right call.

The Winning Formula

The buy side is selecting trading venues to gain access to many of the same things they believe will inject liquidity into the market over the next two years. Access to price improvement continues to top the list when selecting a fixed-income trading venue. This is not surprising, particularly in light of MiFID II and the ongoing focus on best execution in fixed-income markets.

All-to-all and anonymous trading have continued to grow in importance as well, while access to new liquidity was less interesting to the buy side in 2017. This reiterates the buy side’s belief that trading with other buy-side firms will yield greater results and better execution than trading with new, nonbank liquidity providers—at least in the short term. Adoption of all-to-all trading is a virtuous cycle: the more firms involved, the more opportunity for price improvement. And price-improvement opportunities will then attract not only more buy-side participants, but dealer interest as well.

The factors that make for a good dealer relationship are moving in a similar direction. Execution quality increasinglytrumps all else when buy-side traders are determining with whom to trade. The last two years have seen the importance of execution quality jump from making up 49% of the decision to 55%, whereas access to new issues declined from 25% to 20%.

With interest rates finally rising, an expectation that the new-issue market might slow down in coming months is redirecting focus back to secondary market trading. Furthermore, with top-tier asset managers absorbing a considerable amount of corporate bond new issues, middle-market and smaller asset managers increasingly look to the secondary market for the bonds they need.

Getting Orders Into the Market

With venues and dealers selected, getting orders into the market is still most commonly done via the trading venue front ends. While there has been great progress in completely automating odd-lot corporate bond trades (see callout box below), the relatively high-touch nature of even electronic trades in the bond market means the user interface continues to matter. Investments by all the major players in user-experience (UX) design have helped keep those front ends as the primary window into the market for bond investors.

However, there are strong signs that OMSs and EMSs are growing in importance. With the former focused on post-trade data and analytics, and the latter more on pre-trade, the proliferation of trading venues, trading protocols and market data has pushed the return on investing for an OMS or EMS much further into the black.

BlackRock, Bloomberg and Charles River are the dominant names in both categories, all with long histories in fixed income and a strong focus on keeping up with the changing market structure. Other emerging platforms, such as Algomi’s Alfa, TradingScreen and Tethys, are also growing their presence, as the buy side starts to look beyond their internal development teams to rapidly improving third-party solutions.

Moving Forward

The corporate bond market continues to mature, with investors embracing new tools that are finally starting to make up for the dealer balance sheet lost years ago. Technology in and of itself does not create liquidity, but it does provide the mechanisms needed for market participants to more efficiently transfer risk—to everyone’s benefit. If regulations or market conditions move in a direction more supportive of dealers committing capital to market making, that, in combination with the advancements discussed here, will create a market arguably better than the one the buy side enjoyed in 2006.

Methodology

From June through November 2017, Greenwich Associates interviewed 100 buy-side traders across the globe working on fixed-income trading desks to learn more about trading desk budget allocations, trader staffing levels, OMS/EMS, TCA platform usage, and the impact of market structure changes on the fixed-income sector.