Gill Wadsworth explores how bond traders are adjusting to what could become the new volatile normal.
The US corporate bond market has realised the biggest dollar decline since records began more than 20 years ago, while 13.3% was wiped from UK company debt markets; representing the most significant losses since 1998. It is no wonder that one consultant has branded the credit markets ‘ugly’.
The reasons for such dire outflows include rising inflation rates and the subsequent action taken by central banks to try and bring it under control by hiking interest rates. This has all been against a background of economies trying to recover from the Covid pandemic while simultaneously dealing with the fallout from Russia’s invasion of Ukraine.
Research from Coalition Greenwich, which conducted a series of qualitative interviews with a dozen traders from major US buyside and sellside institutions, reports, “The first half of 2022 has proven ugly for credit markets. Buyside traders are struggling with key challenges tied to data accuracy, their reliance on dealer balance sheets and implementing new, more-automated workflows to bring it all together. Given the plethora of market frictions born out of macroeconomics, geopolitics and the aftermath of Covid-19, participants are keen to find proactive ways to make lemonade out of illiquid lemons.”
“For decades, bonds have been a one-way bet, as each monetary cycle has seen progressively lower peaks in rates,” says David Rickard, director, rates trading solutions at LSEG. “The recent changes in economic and market conditions have seen a break in that trend, with many bond funds facing severe losses and investor withdrawals. As a result, fixed income investment strategies have needed to adjust. The focus has changed from a “search for yield” to protecting capital and shortening duration.”
Top of the worry list
According to Coalition Greenwich, at the top of bond traders’ “worry list” is the need to source liquidity against a backdrop of consistent market volatility. This is at a time when bank counterparties and their capital are needed the most, balance sheets have shrunk, and bid-offer spreads have widened to account for new market risks.
The knock-on effect, the research finds, is that buyside traders have lost some of their faith in the market data on which they have come to rely over the past decade, with bond prices not behaving as they once did.
Raj Paranandi, chief operating officer for EMEA at MarketAxess, says. “In this environment there is a lot of liquidity fragmentation, and it has been very hard for banks to be there with a price because first, at some of these peak points and volatilities, everyone is selling. Second, the capital rules for broker dealers, which have changed a lot in the last 15 years since the financial crisis, really bite when there is market turmoil.”
It is no surprise then that the traders surveyed by Coalition Greenwich want aggregation of liquidity, firm price commitments on both sides of the market, and to connect with natural counterparties.
Jim Toffey, CEO at LTX, Broadridge Financial’s artificial intelligence-driven, electronic trading platform, believes more must be done to enable buyside traders to trade with each other. “It makes more sense to connect the natural buyer with the natural seller; in other words, the buyside to the buyside. But I could be looking to sell $10 million in bonds, and there’s a buyer out who wants them, but we aren’t talking to each other, so we never connect the dots.”
To better connect the dots, LTX has created what Toffey calls a ‘liquidity cloud’ where – facilitated by a trader – the two sides of a deal can find one another.
“The liquidity cloud is where you can share what you’re willing to buy and sell, and others can too. And then I’ll give you a real time liquidity score based on what you’re trying to buy and sell versus what everybody else is trying to buy and sell, to give you a probability of the natural liquidity.” Toffey adds, “Any portfolio manager now has access to an independent, real-time view of the natural liquidity.”
Unreliable data
The Coalition Greenwich research also highlights traders’ concerns with data, or more precisely the lack of it. “Although the importance of good data can’t be understated, traders we spoke with indicated it can be a fickle friend. This is especially true in opaque markets, where there is a dearth of pre-trade transparency, misleading interest and slippage is commonplace,” the research states.
Respondents to the survey say they lack confidence in fixed-income data and believe “about half of it is really reliable”. Additionally, they have come to accept the inverse relationship between volatility and usable data, describing it as “par for the course.”
Traders indicate that vast amounts of fixed income data have become even less reliable, “with volatility spikes and liquidity getting spotty”.
Coalition Greenwich says this means data is creating ‘haves and have nots’, as some market participants struggle to figure out ways to aggregate and consume information more effectively and to separate out the good from the bad.
Overall, the research finds, there is persistent belief among bond investors that fixed income data will, over time, continue its march forward via improved accuracy and timeliness.
Paranandi notes, “There is a real thirst from our clients to see as much data as they can, particularly on a pre-trade basis. For years it has been really hard to get that data to people because it was unstructured, so pulling it all together and generating any insight was a challenge. We are now at the point with the evolution of tech, where we can do that.”
Nearly 40% of study respondents said that seamless integration with their order management system (OMS) and execution management system (EMS) providers is crucial for e-trading platforms to gain critical mass and make true progress toward more electronification and automation in corporate bond trading.
By embedding pre-trade data in portfolio management workflows and providing flexible new execution protocols to traders within their OMS/EMS, platforms can offer innovation and efficiency within existing workflows without sacrificing precious screen real estate.
Paranandi says, “Automation technology isn’t just about algos, it is about allowing people to simplify some of the things that they do in their existing workflow. It can be a kind of auto responder style to manage more complex business rules, such as giving users the opportunity to configure the way that they use different liquidity pools.”
Looking to the coming year, LSEG’s Rickard says that while it is too soon to predict the outlook for inflation there are early signs that rates may be peaking. He adds that that continued rises in interest rates will be unsustainable, but they will remain volatile, meaning traders must stay vigilant.
“Despite the significant increases seen this year, interest rates remain towards the lower end of long-term historical range,” he adds. “As a result, desks will need to remain flexible with their approach. It seems increasingly likely that many countries will face challenges to economic growth this year and next. This adds more uncertainty for medium- to long-term trading strategies.”
This demands constant focus from traders on achieving better ways to trade electronically with more emphasis placed on workflow efficiencies.
But, as the Coalition Greenwich research states, “How quickly the buyside gets to this state will depend on the willingness of traders to accept that some of the workflows and methods they’ve relied on in the past just don’t cut it anymore, and that it’s time to try something new.”
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