The astonishing rise in passive investment often begs the question of how much influence these investors now have on corporate bond market liquidity: can the exchange-traded fund tail can now be said to be wagging the market dog?
The answer to this question lies not only in the volume of assets now held in corporate bond ETFs (which has topped $1 trillion) but also in the changes in market behaviour that this has facilitated.
Perhaps the most important of these in trading terms is the recent growth in portfolio trading, whereby a basket of multiple bonds of varying duration and credit quality is traded in a single transaction.
The portfolios are offered to a discrete group of maybe two or three dealers who are able to offer bids very quickly on the whole pool. A demonstration of Tradeweb’s portfolio trading platform at the firm’s London office shows almost instantaneous bids on a speculative portfolio of 300 bonds from three separate dealers.
“There is huge appetite from asset managers, which speaks to the kind of workflows they have: for example, putting cash inflows to work in a way that replicates a fund’s existing strategy or rebalancing a portfolio to ensure both buys and sells get done the same day,” says Chioma Okoye, European credit product manager at Tradeweb in London.
“Portfolio trading has increased the percentage of bonds that can trade daily; now if you are time constrained, you can get a package done where every bond will get a price.”
Wall Street firms have closed more than $88 billion worth of portfolio trades over the last two years, according to Bloomberg. These trades are now gaining in popularity in Europe too, with Okoye telling Euromoney that by the end of February her firm had seen $6 billion of enquiry from European firms.
It is not hard to see why bond portfolio trading has become so popular. In a market characterized by off-the-run illiquidity, parcelling up baskets of bonds is a neat way to move securities that would otherwise be very illiquid on their own.
Dealers have sophisticated tools to assess the overall risk profile of the whole basket in a portfolio trade that enables them to take on the less-liquid bonds as part of the package.
Portfolio trading has increased the percentage of bonds that can trade daily; now if you are time constrained, you can get a package done where every bond will get a price
– Chioma Okoye, Tradeweb
“Portfolio trading is a discreet and highly efficient way to trade a basket of bonds with varying liquidity,” explains Okoye. “You can trade much bigger packages and far less liquid bonds.”
Both Tradeweb and MarketAxess have launched portfolio trading platforms in recent months.
Tradeweb was the first out of the gate, offering a platform that allows users to submit portfolio trades to multiple liquidity providers simultaneously.
MarketAxess launched its portfolio trading protocol in mid November, and offers clients the ability to trade up to 1,500 bonds and submit to up to five dealers.
Another attractive aspect of trading bonds in this way is secrecy. By submitting the portfolio to a small number of targeted dealers, it is largely kept under wraps until the trade has been completed.
“With a portfolio trade you tend to go to several dealers without showing the portfolio to the wider market,” says Alex Temple, portfolio manager for the credit Europe team at Wells Fargo Asset Management. “If the portfolio is reasonably diverse and liquid, then turnaround times from the dealers are pretty swift.”
Angela Lobo, fixed income, currencies and commodities sales COO at Morgan Stanley, has seen the impact of this over the last couple of years.
“In 2018 and 2019, we would look at a slice of trades and analyze what kind of prices clients were getting back,” she says. “Sometimes they wouldn’t get enough prices to suffice their best execution requirements, so we were able to persuade people that you can get a far better and more competitive price this way.”
While it might be assumed that portfolio trades would be the preserve of managers with large volumes of assets under management, it is clear that there are indirect benefits for everyone.
“The advent of portfolio trading helps smaller firms,” says Keshava Shastry, head of capital markets at DWS Group. “When you are buying single-name bonds as a larger client you get a better price and better service during volatile times. This [portfolio trading] will help smaller clients as there will be a standard price, scalable process and automation.”
That could be a lifeline to smaller investors who struggled to achieve allocation during the bond market bull run. The irrevocable shift of market liquidity towards index-style products could, therefore, give these firms access where there was none before.
Okoye goes further, saying that the advent of portfolio trading has encouraged reinvigorated appetite in some corners of credit investment.
“We are seeing new business from new areas,” she says. “Customers who were not historically active in the credit space electronically are now coming in, and we have seen both large and smaller asset managers getting interested.
“Trades have tended to be one direction so far,” she adds. “There have been some that are risk neutral, but we have seen that less.”
It is hard to see the rise of portfolio trading as anything other than positive for the bond market. It is making liquidity available where it was not available before and is going some way towards redressing the widening imbalance between large and small buy-side firms when it comes to the allocation and pricing of bonds.
Constantinos Antoniades, global head of fixed income at Liquidnet, agrees that portfolio trading creates liquidity.
“Portfolio trading won’t encourage new investors into credit, but it arms asset managers with another way to source liquidity,” he says. “So far, it accounts for a small part of US market volumes – and even less than that in Europe – but it will likely continue to increase over the next few years as it becomes more mainstream and as different flavours of portfolio trading emerge.”
Liquidnet is currently building a portfolio construction tool that will enable asset managers to crowdsource liquidity for new portfolios or lists of bonds, by leveraging the liquidity in the platform.
“This will also widen the options that asset managers have for portfolio trading,” Antoniades says, while also cautioning that the liquidity impact of portfolio trading should not be overstated. “It is a useful tool in certain circumstances, but it won’t take over how asset managers move risk on a daily basis, a lot of which is still idiosyncratic and hard to tie to a larger portfolio trade.”
Big advances in bond market automation are behind the pickup in portfolio trading that the market is now witnessing. Temple explains how the shift in focus by traders to larger tickets has benefited everyone along the food chain.
“Algo trading has had a positive impact on liquidity,” he says. “It has freed up sell-side traders to focus on larger tickets, with the algo handling the smaller-sized tickets. We can now easily trade vertical slices of portfolios via list trading [which allows traders to execute multiple trades simultaneously] and portfolio trading is the next logical step.”
Shastry at DWS emphasizes how far the market has come.
“A few years ago, we converted from synthetic to physical replication,” he tells Euromoney. “We had to unwind swaps and physically track the bonds, which meant we needed to buy hundreds of bonds to give us the index tracking we wanted. We started this for bonds in 2016 and, even then, it was a fairly manual process and an active conversation with brokers. Now, with automation, it is getting more efficient and easier, but there’s still a long way to go compared to equities.”
ETFs are transparent, low-cost and efficient, so understandably they were viewed with suspicion and resentment
– Andrew Jamieson, Citi
He extols the virtues of the flexibility now on offer: “Portfolio trading goes hand in hand with ETFs. When we create, we might only want a small basket of bonds in the index rather than all the bonds in the index or all the bonds that are currently held in ETFs.
“We have some very large bond clients now coming into ETFs who have a portfolio of bonds and want to swap into an ETF as it is much more efficient and easier to manage. We can work with authorized participants to deliver the portfolio, get rid of the bonds we don’t want and buy the ones that we do to make it more relevant for the index that we are tracking. It is a much more high-touch conversation.”
Such trades are just one by-product of the extraordinary increase in bond market ETFs in recent years.
Andrew Jamieson, global head of exchange-traded products at Citi, explains: “If you go back four or five years, you would conclude that the big four had sewn up the ETF market, but the industry has evolved and these are no longer viewed as passive-only products, and rather as a technology or the mutual fund v2.0.
“There are going to be an indefinite number of new players who will come to market to protect their existing businesses.”
Jamieson, formerly global head of relationships at iShares, joined the bank in November 2017 to help build its ETF business.
So, far from just being a useful option at the periphery for asset managers, ETFs are now emerging as the vital core of any bond-market strategy. And this is because of the liquidity that they facilitate.
“There has been an acceleration to indexation/electronification in fixed income,” says Jamieson. “Outside of the mega asset managers, it is very difficult for smaller players to get primary allocation in bonds, so people can buy the ETF instead or unzip it. This gives huge flexibility.”
It is hard to overstate just how much of a change to the trading environment this represents.
“Traditionally, fixed income was characterized by phone calls, relationships and opacity,” continues Jamieson, “you had to be part of ‘the club’. Conversely ETFs are transparent, low-cost and efficient – the exact opposite – so understandably they were viewed with suspicion and resentment.”
This leaves today’s bond market participants facing several questions. For large firms, is having an ETF business now essential? Does the fact that firms such as Fidelity, Franklin Templeton, Goldman Sachs Asset Management and Legal & General Investment Management have all launched them in recent years indicate an unstoppable momentum?
Speaking at an event in London in February, financier Huw van Steenis – fresh from delivering his review of the future of finance to the Bank of England – pointed out that the cost of an ETF has fallen by 92% in a decade.
“If it hadn’t been for the bull market, that would have been crushing for asset managers,” he said. “Revenues for the top five online brokers in the US fell 20% last year; if your unit price falls that much, you need scale. Things will be OK for the top three, but this crushes everyone else. It is a profound change.”
While observations such as this are predominantly focused on the equity markets, the same holds true for credit. Certainly, if portfolio trades are unlocking previously untapped liquidity in the bond markets and such trades require an ETF to replicate the portfolio, then it would seem that the ETF takeover in fixed income is a done deal.
Not everyone sees the link between ETFs and portfolio trading as unbreakable, however. Yes, ETFs have driven the technology that has made portfolio trading possible in the bond market, but they are not a necessary requirement for portfolio trading to grow.
“For us, the core building blocks for our portfolio trading are our automated market-making model and broader voice franchise,” explains Phil Allison, global head of automated trading in fixed income at Morgan Stanley. “If there is liquidity in any other highly correlated risk asset such as an ETF, then yes, we will obviously use it. But do you need ETFs to trade the portfolio product? No.”
The large US firms were first to recognise the impact that the rise in passive investing and ETFs would have on the fixed income business. Citi was an early advocate for adjusting the trading desk to reflect this.
“Three or four years ago when we were first talking to clients about the irreversible rise of passive and adoption of ETFs and what it would mean for them, Paco Ybarra [head of Citi’s institutional clients group] challenged the ICG team to ask themselves the very same thing,” recalls Jamieson.
“We realized it didn’t make sense to continue trading all ETFs under our delta-one group, which is an equities business – after all what would they really know about the inner workings of the credit, munis and rates world? So, we broke out by asset class and created a new fixed income ETF trading group under Jay Mann and a parallel commodities ETF trading team.
“These traders understand what the exposures represent and, importantly, have access to the firm’s huge inventory in the underlying securities.”
Euromoney spoke to Mann in March last year, when he explained how heavily the bank was investing in its ETF offering.
“We are radically changing the way in which we move risk around,” he told us. “We are using ETFs for liquidity and we are embedding them as part of the execution strategy. For over-the-counter securities, you can get 85% of the portfolio through MarketAxess and Tradeweb, but you then have a 15% tail – and you can’t get these bonds. With portfolio trading, you pay a bit more, but that 15% becomes the dealer’s problem.”
The growth of ETFS has also created far more operational flexibility in how both dealers and asset managers can operate. For the banks, this means that they can hit bids in an almost seamless fashion.
“Order books operate in different ways,” points out Vasiliki Pachatouridi, head of EMEA iShares fixed income strategy at BlackRock.
“Accessing liquidity for fixed income ETFs, you have to take into consideration a number of things beyond trading volumes and bid/ask spreads. Banks and dealers currently have a lot of instruments to hedge their bond ETF positions, which has increased their ability to offer risk prices even when the underlying bond markets are not open.”
We do not necessarily use ETFs for hedging portfolio trades, but they might be useful in some cases. Using ETFs alone to hedge would limit the bond universe in a portfolio trade
– Mehmet Mazi, HSBC
Brett Olson, head of iShares fixed income, EMEA at BlackRock in London, adds that the scale of the ETF market now also makes the portfolio trader’s job easier as it represents a bond repository that they can dip in and out of.
“This is a big part of the Ucits [Undertakings for Collective Investment in Transferable Securities] market,” he says. “You can adjust the create-and-redeem baskets throughout the day – you are not beholden to the basket, given our funds are diversified and sampled. If you find that bonds are getting rich relative to the benchmark, then you will adjust the basket. This is to ensure the portfolio continues to efficiently track its benchmark.”
Inevitably, as more and more fixed income portfolio managers operate in this way, the needs of ETF traders will come to dictate trading practices across the whole bond market. For ETFs, timing is everything. They need to trade portfolios in one go because most trades need to be executed at a specific reference level to get a valuation fixing so that there is a perfect match between the valuation of the create-and-redeem.
“You need a really specific match between valuation of the create/redeem for the ETF and the price applied to the trade,” says Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing and Smart Beta. “The stage between valuation fixing and execution price will create a tracking error on the ETF.
“Executing on the close is a very common practice for equities and has been for years,” he continues. “Today, the close really concentrates liquidity in the equity world. Bonds have no equivalent reference fixing, which concentrates liquidity like this. That is why fixed income ETF passive fund managers need to execute on the specific fixing.”
And the rest of the market needs to get used to it. “Clients create and redeem in time with the ETF provider, and other types of fixed income clients tend to get adapted to the situation.”
Nevertheless, there is still pushback against the idea that ETFs now rule the bond-trading universe and that the ebb and flow of liquidity is largely determined by them.
“The first time we were asked to price up a portfolio trade, it had nothing to do with an ETF,” reveals Mehmet Mazi, global head of debt trading and financing at HSBC. “We do not necessarily use ETFs for hedging portfolio trades, but they might be useful in some cases. Using ETFs alone to hedge would limit the bond universe in a portfolio trade.
“Our portfolio trading function is independent from the rest of our market making functions,” he reckons, insisting that the sophistication of the trading environment means that portfolio trades can now be assessed independently.
“We can see the risk profile of our whole business before and after a portfolio trade in minutes,” he explains. “We can see the utility of that portfolio: interest rate risk, duration risk, rating transition risk, etc. We can measure the key contributing factors to establish the price. We might get a portfolio trade that may actually de-risk the business.”
It is news to no one that the greater use and adoption of electronic trading, data, analytics and machine learning across the bond market will drive liquidity and result in better pricing. ETFs may have spearheaded this process, but as portfolio trading is more widely adopted, it will only accelerate it.
“If the growth we have observed in the fixed income ETF market continues for the next few years, then yes it will become a much bigger part of fixed income trading,” agrees Guignard. “There has been a transfer of assets from active funds and from direct management. Smaller fixed income asset managers, who will never have the pricing power of big ETF players, will benefit from the liquidity offered.”
These developments mean the trading environment for corporate bonds is almost unrecognizable from just a few years ago.
“There is an evolution in the ecosystem,” says Allison at Morgan Stanley. “Anyone can argue which is the dominant factor between ETFs, portfolio trading and autonomous market making, but it is all three together that are changing the landscape.
“We are getting the ability to trade block risk in odd-lot form. And we now have the ability to disseminate odd-lot risk at a reduced operational cost.”
This doesn’t sound like that much of a big deal, but it is. Any innovation that increases liquidity in the corporate bond market is of great importance to dealers, asset managers and corporate issuers alike.
The implications of this will become all too apparent as the market struggles to recover from the unprecedented 27% drop it suffered on March 9, and battles with the fallout from the current coronavirus-driven volatility.
Portfolio trading may add to US advantage
With US firms reporting nearly $90 billion worth of portfolio trades last year, the expectation is that a similar volume of business will soon be taking place in Europe.
But the two markets are very different and there is no guarantee that this will happen – indeed, the growth of portfolio trading in the US could further compound that market’s existing liquidity advantage.
“The US is running six to nine months ahead of Europe on this,” explains Phil Allison, global head of fixed income automated trading at Morgan Stanley. “We started to get a lot more questions on portfolio trading in Europe in early 2019. Two things make this harder in Europe: there is less price transparency and it is a little less of a flow business.”
The US market has the advantage of having more transparent pricing data from a centralized consolidated tape. This means traders can extrapolate the prices of underlying portfolio trades much more easily. In Europe, which relies on the request-for-quote model, there simply aren’t the continuous firm prices that are needed for low-touch algorithmic trading strategies.
“In the US, clients are very comfortable doing a trade with a single dealer because they can see the ECN prices and know what the price should be,” explains Angela Lobo, head of Europe credit market structure at Morgan Stanley. “In Europe, it is still a price-discovery protocol.”
Unsurprisingly, therefore, Lobo is reasonably cautious on uptake in Europe.
“We did see a substantial increase in liquidity in Q4 last year,” she tells Euromoney. “We had spent the first half of the year working with client compliance teams, so this was driven by clients wanting to try it out. A year ago, a portfolio trade was a rare event. Now it is an everyday occurrence. But we don’t want to overstate it. It is growing very rapidly, is a relatively significant part of the European credit complex, but it is not a dominant part.”
It doesn’t help that as asset managers went through the implementation of the EU’s updated Markets in Financial Instruments Directive (Mifid II), they defined their best execution processes.
“We suddenly started talking to them about a different process that was different from this, so it required more effort for it to fit into best execution,” recalls Allison.
A year ago, a portfolio trade was a rare event. Now it is an everyday occurrence
– Angela Lobo, Morgan Stanley
Mifid II also puts the onus on the asset managers themselves to demonstrate best execution. Andrew Jamieson, global head of exchange traded products at Citi, argues that portfolio trading helps them to achieve this.
“When trading fixed income ETFs as an example, there are typically three ways to trade: on risk, versus NAV or the traditional agency route,” he explains. “A portfolio trade replicates the traditional agency route, and clients thereby benefit from the broadest possible liquidity pools.”
Interest has been picking up in Europe.
“The pace of adoption in Europe has been quicker than anticipated,” reveals Chioma Okoye, European credit product manager at Tradeweb in London. In mid February she told Euromoney that the firm had already seen over $2 billion worth of inquiry on the European side and that the pace of inquiry was running at more than one a day on average.
That is still a far cry from the figures coming out of the US, but it is a start. The European market differs structurally from the US market, and there are good reasons to argue that, in a region where regional banks can still source good liquidity in their domestic markets, portfolio trades may never take off to the same extent.
“Despite the recent prevalence of algo trading and increased liquidity from ETFs, we believe the uptake of portfolio trading in Europe will lag that of the US,” says Alex Temple, portfolio manager for the credit Europe team at Wells Fargo Asset Management.