The decision by many of the world’s central banks to keep interest rates low – as a counter to the weak macro-economic environment and to foster growth – has encouraged many companies to issue new bonds at a relatively low cost of borrowing. At the same time, the potential for higher returns from these bonds makes them a lucrative proposition for many investors – particularly institutional investors, such as pension funds and insurance companies. While the high growth in corporate bond sales has been witnessed in the short- to medium-term in the developed markets, in the emerging economies it has been happening for rather longer. Buoyed by long-term growth opportunities, companies from the emerging markets (EMs) have been issuing bonds to raise funds from global and local investors for over a decade now.
While the activity in the primary market – where sales of new bonds by issuers to investors take place – has been growing steadily, the secondary market – where trading of such bonds take place among different types of investors (and market makers) – has been an issue of concern. There are a number of reasons behind this difference. A number are related to the structure of the corporate bond market and have been there for some time, while others are more recent and result primarily from changing regulations introduced in the wake of the 2008 global financial crisis.
Buyers of corporate bonds, particularly those in the EMs, typically hold on to them until maturity. This means the pool of securities available for sell in the secondary market is not very deep. The resulting illiquidity means the cost of trading (bid-ask spread) in the secondary market can be substantial, especially compared to other asset classes such equities or FX.
The problem is exacerbated by the lack of standardisation among issued bonds. Different corporates issue bonds at different points of time, with varying tenors and coupon rates purely based on their specific requirements. Consequently, the terms of bonds issued by the corporates may vary significantly. Even the bonds issued by the same company at different points of time can have different terms, unlike that seen in the case of equities. These issues limit the choice of investors in the secondary bond market. An illiquid secondary market can, in turn, have an impact on the primary market. When investors know that an exit option (selling a bond before maturity) is limited, they may not participate in the primary market.
This gap is typically filled by dealer banks, which act as market makers by taking their own positions and buying bonds from sellers or selling them to buyers. In fact, the secondary market in corporate bonds has been traditionally dominated by the dealers; a separate exchange market connecting investors to investors has yet to develop to any great extent. However, recent regulations introduced in the wake of the 2008 crisis have made this task of market making very expensive for the dealer banks because of which many of them have significantly reduced their inventories, thereby limiting their roles as market makers.
For example, dealer inventory has shrunk by around 75% in US corporate bonds compared to 2007, while outstanding bonds have grown by over 50% during the same time. This means investors now have even fewer choices of exiting the bonds they have in their accounts. According to Mark Carney, the governor of the Bank of England (BoE), it now typically takes seven times as long to liquidate bond portfolios than it did back in 2008.
As some of the world’s central banks consider starting to interest rates again, many investors are expected to sell their bonds. If there are too many sellers with only a handful buyers and market makers, that can have serious impact on the already distressed market and the asset class as a whole.
Over the past few years, efforts have been made to develop a viable secondary market, by connecting investors and dealers to other investors and dealers through (all-to-all) exchange-type electronic trading venues, in contrast to some dealer-to-dealer or dealer-to-client venues in place. Here, dealers will not be the central agents of the market; even two investors can connect to each other through the venue to complete a trade. Following other asset classes such as equities and FX, where electronic trading has already become popular, the entry of such platforms in the bond space would be a logical extension.
Further electronic trading is also on the regulators’ agenda as they seek to improve transparency in trading in all asset classes. Trading in bond is still dominated by the voice (over the phone) execution method and so far the extent of adoption of electronic trading is relatively limited. Structural shifts taking place in this market may finally expedite this process. A number of players, such as Tradeweb, MarketAxess and Bondcube have developed – or are developing – trading platforms. Even some of the leading exchanges, such as the SIX Swiss Exchange and the Singapore Exchange (SGX), are looking to add bond trading platforms as part of their strategy to support trading in multiple asset classes. These new trading platforms have the potential to improve price discovery in bond markets and reduce trading costs, boosting investment returns in the sector.
While all of these sound perfectly logical, one key challenge would be to first change not only the mind-set but also the technology and operational practices of the participants in this market. Moving away from a phone-based trading desk to electronic tools will require adequate investment and know-how for running the operations. Market realities and the education of buy side participants should lead to the greater adoption of electronic trading tools, as their features become more widely known.
What will ultimately change the nature of the markets substantially are not just electronic trading tools but a robust best-execution rule, which requires an interconnected market. As orders start to migrate to electronic platforms and an increasingly interconnected market appears, aggregation and distribution technology will be required to support this evolution.
These issues can be handled at the level of trading venues and trading members and, if dealt with properly, should contribute to a more electronic market. However, lack of standardisation will still be a challenge and is something that can only be addressed by the issuers, and therefore may take time. If and when that happens, it should expedite these electronification efforts hugely.
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