Desk Research: Buy-Side Bond Liquidity in the US Midmarket

Fixed income liquidity to become more centralized

In 2022, despite strong secondary trading volumes, many buy-side firms are reporting deteriorating liquidity conditions and traders have seen lower trading returns in the second half of the year.

Bond market liquidity has traditionally been supported by traders leveraging their balance sheets to buy from or sell to their clients and then trading those stock positions with other clients at a profit.

However, these sell-based firms face barriers to supporting the provision of liquidity to clients, due to current market structure, regulatory constraints and current volume of activity, and interest rate movements.

There are many indications of pressure on market performance. For example, the Federal Open Market Committee (FOMC) started raising its target interest rate on March 17, 2022 and in the intervening period, Corporate bond market distress index The CMDI rose from 0.13 to 0.27, representing a change “from the 13th percentile to modestly above average historical bond market conditions,” according to Fed economists.

“Looking at different types of corporate bonds according to default risk, the High Yield Index (HY) remains slightly below the historical average, but the Investment Grade Index (IG) is in the top quintile, indicating pressures in market performance,” they note. .

To assess current conditions from a buy-side perspective, the bureau spoke with 30 US asset management firms to measure their access to liquidity, dealer engagement, data usage, and electronic trading.

Executive summary
In fixed income markets, it is understood that pricing levels differ between market makers and customers. To minimize any limitations on the results, our survey solicited feedback from 30 mid-tier asset managers in the US fixed income market.

We found that their access to liquidity is considered between average to poor by the majority of respondents. A large majority indicate that access to liquidity has either worsened or has worsened significantly over the past year. This is perhaps not surprising given the previously well-documented lack of transparency of trade, the current rising rate environment, and shrinking balance sheets.

Although respondents largely agree that access to liquidity has worsened, they still often seek out traditional trading routes. In general, respondents said they interact more frequently with first-tier traders than with second-tier traders. As fragmentation and volatility continue, it is reasonable to believe that data and technology can level the playing field in terms of access to liquidity through the aggregation of information and better connectivity with traders.

The majority of respondents agreed that trading in higher volumes is the most difficult goal to achieve. Electronic trading is used much more for smaller trades, and is rarely (or never) used for larger trades including blocks.

In general, alternative methods for analyzing liquidity before a trade and for executing medium to large trades are not currently being used despite the upside they offer to traders and managers.

Survey results:

Access to liquidity
Bond traders have had a tough year in 2022. Access to liquidity is cited as a major issue. Only 10% of respondents report that access to liquidity is easy, just over half (53%) consider it moderate, and more than a third (37%) report it difficult (Fig. 1).

Seventy-seven percent of respondents said that access to liquidity has worsened, and 20 percent of them indicated that access has worsened significantly. 17% of companies indicated that they did not see a change in liquidity conditions, but only 7% reported an improvement at the same time (Figure 2).

liquidity discovery process
The way investors search for liquidity is changing. Electronic corporate bond trading is on the rise, indicating not only the desire or need to explore new trading protocols, as well as sources of liquidity.

Research published by analyst firm Coalition Greenwich found that electronic commerce in credit has increased since 2021, with 40% of US investment deals and 37% of high-yield trading conducted electronically in October 2022, up 7% and 9%, respectively. Total average daily volume in October increased by 12%.

Other research from Acuiti found that 79% of traders reported that their clients had slightly or significantly increased their online trading this year.

We found that most companies have adopted e-commerce, with only 12% of respondents reporting that they have not used electronic trading platforms before.

Orders under $1 million are handled frequently or fairly frequently electronically by the vast majority of respondents. Orders of $1-5 million are electronically traded frequently or fairly frequently by more than three-quarters of respondents.

Perhaps unsurprisingly, larger orders are traded electronically less frequently, with 48% of respondents saying they never use electronic trading for orders between $5-10 million and 64% saying they never use electronic trading for orders over 10 million US dollars. Historically, large trades tended to be the domain of voice trading/introducing broker, while electronic trading contracts tended to be much smaller (Figure 3).

What isn’t clear is whether the lack of wider e-commerce adoption of blocks is due to previously failed efforts to trade larger volumes in the past, or if the scarcity of online platforms to trade larger volumes has impeded their ability or interest in doing so. .

While the adoption of technology for executing micro trades continues to increase, most respondents have not incorporated data science into their liquidity discovery processes. Efforts to use data science to assess liquidity and find natural counterparties before a trade appear to be limited, with 63% either rarely or never using data science in this regard. Only 10% of respondents frequently use data science in this way, with 27% using it occasionally (Figure 4).

Implementation goals
Liquidity can be measured differently based on execution objectives. Volume and price are two of the major components when determining the tradability of a bond. When asked which goal proved most difficult, 37% said volume, 20% said price, and 23% said volume and price. 23% were given alternatives, with various criteria including, “Get an offer when the market moves” and “Qualified high dollar or non-eligible securities” (Fig. 5).

Who provides liquidity?
As buy-side firms are exposed to increasing business pressures including declining product margins and rising costs, they often need to rationalize their merchant relationships. Banks play a crucial role in managing new deals in the primary markets, providing research and market color, as well as providing secondary trading.

We looked at the level of engagement among survey respondents as Level 1 Traders and Mid Level Agents. We consulted with participants about how and why they approach the sell side.

Most respondents interact with Level 1 traders frequently, whether it is to access new issues or for secondary trading of bonds. The level of firms that rarely interact with these dealers – 22% – could account for the level of buy and hold activity they engage in, or even the limited coverage they get from merchants.

With 77% engaging either frequently or fairly frequently, Tier 1 sell-side companies get the lion’s share of interactions. (Fig. 6)

Interacting with mid-level traders is much less common, as 40% of asset managers rarely interact with them. Only 37% reported interacting frequently with these merchants. In conversation with respondents, we found that this was due in part to the limited and specialized use of smaller dealers, lower volume dealer lists and the underlying level of activity that occurs with Tier 1 companies. (Figure 7)

Respondents’ views on participation
Survey respondents were asked to make qualitative suggestions on how to improve fixed income credit coverage. Their answers fall into roughly five categories: breadth of information provided, relevance of information, aggregation of information, balance sheet commitment, and ability to holistically support the agent-client relationship.

In the first category, respondents said they needed broader name coverage with broader stocks and showing more opportunities.

They shared concerns about the importance of the information, and examples of desirable improvements included the quality of the hubs, and the most relevant business ideas.

The need to aggregate information more easily was a challenge for many respondents, citing the number of screens/interfaces needed to access merchant information, and a preference for merchants to be more careful about where execution occurs.

The desire to see more balance sheet compliance has also proven to be an issue that has raised concerns across the industry. Traders report that regulatory constraints and costs imposed through regulatory capital ratios are a major impediment to providing clients with a balance sheet.

A final concern has been the overall relationship support clients want, with there often being a disconnect between primary capital markets/investment banking and secondary market activity.

demographics
We surveyed 30 mid-tier asset managers in the US, who invested primarily in both high-yield and investment-grade bonds.

How can companies improve access?
Based on the survey results, most mid-tier asset managers have moderate to poor access to liquidity, with conditions deteriorating.

Buy-side clients identified pre-trade information, such as pivots – or lack thereof – and balance sheet provision as leading challenges.

Electronic trading has helped by providing better access to sources of liquidity, but there is still a lot of opportunity for improvement in terms of using data science and new technology to discover liquidity more efficiently than natural counterparties and electronic trading.

Large trades tend to be the area of ​​sound trading/ID, with survey respondents reporting volume as the hardest execution goal to achieve.

“Exploring high-volume deals though electronic means can open up new channels for liquidity,” said one respondent on the buy side. “This is incredibly valuable when liquidity is diminishing more broadly in the market.”

Although e-commerce is currently focusing more on smaller trades, new electronic protocols for block trading are emerging which can bring new efficiencies to trading large orders.

Despite the advent of data-informed e-commerce solutions, very little data science is currently being used to find natural counterparties to trade with. Data science has the potential to allow for more accurate services from merchants to customers, with more targeted engagement allowing for less information leakage, resulting in more efficient selling-side and buy-side trading.

Conclusion: E-commerce and data science are critical in a fragmented market environment
The fragmented dynamics of the corporate bond market mean that communication and information are crucial. Active engagement with merchants across the sell-side community is imperative. The need to fulfill large orders quickly and efficiently is more pressing than ever.

According to one buy-side respondent, “When traditional methods of market engagement do not lead to execution, the trading desk should consider how to find liquidity in another way. This could include better pre-trade analysis, and more effective use of electronic trading.”

Based on the insights of the survey respondents, the opportunity to take advantage of electronic trading and data science tools is becoming more urgent given the challenging market environment.

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