The US corporate bond market has a rich, centuries-old history that more recently has been overshadowed by the stock market. In fact, when the New York Stock Exchange (NYSE) was founded in 1792, it was mainly as a bond exchange for the new US government’s debt. In the following century, railroads were built across the US and financed by corporate debt. Alongside the relative rise of cash equities in the 20th century, bond trading shifted to over-the-counter (OTC) markets where, to date, it has largely stayed.
Beginning in 1998, the Securities and Exchange Commission (SEC) prompted the National Association of Security Dealers (NASD) to consider regulations requiring reporting of trades in the secondary market for US corporate bonds in an effort to improve transparency. At the time, the then-SEC chairman, Arthur Levitt, said: “Investors in the corporate bond market do not enjoy the same access to information as a car buyer or a homebuyer or, dare I say, a fruit buyer. And that’s unacceptable. Guesswork can never be a substitute for readily available price data.”
Levitt also called for increased price transparency in the corporate debt market, commenting in a speech entitled ‘The Importance of Transparency in America’s Debt Market’, at the Media Studies Center in New York on 9 September1998, that: “Investors have a right to know the prices at which bonds are being bought and sold. Transparency will help investors make better decisions, and it will increase confidence in the fairness of the markets. Simply put, it’s in everybody’s interests.”
The Era of TRACE
The drive towards improved transparency culminated in 2002 with the NASD’s implementation of the trade reporting and compliance engine (TRACE) system for reporting trading in the secondary market of US corporate bonds. TRACE is now managed by its new parent, the Financial Industry Regulatory Authority (FINRA), which was formed by the 2007 merger of NASD and NYSE’s regulatory divisions. TRACE provides for post-trade price transparency in US corporates, currently 15 minutes after the trade. Functionally, this roughly equates with US cash equities printing to the tape. TRACE reporting was roughly the last major innovation in transparency for US corporates.
Prior to TRACE US corporate pricing was largely opaque; under TRACE all prices and sizes of trades became public after the fact. The change induced pressure on pricing throughout the trading workflow, as ultimately a price’s fairness would come out once a trade was printed on TRACE 15 minutes later. By some estimates trade execution costs – i.e. premium to par value – were halved when this practice began. Today, all trades are subject to reporting and post-trade transparency is in full effect for US corporates.
While electronification has come to US cash equities, equity options, futures, US Treasuries and European bonds, it has yet to take full hold in US corporates. However as a ‘slow market’, where the transactions are typically to buy and hold, it could be argued that electronification has as of yet proven unnecessary there. It was initially promoted by the very banks that dominated secondary trading in US corporates via principal trading in and out of their inventory.
As in many electronification efforts in capital markets, the motivation was less about transformation than about further solidification of profit. Unlike so many other capital markets, however, there has been little legislation and regulation imposing electronification, and it could be said that the US corporate market has been left to its own devices and evolved per market participants’ desires.
The Current Landscape
While legislation and long-term regulation directly impacting US corporates has been small, recent efforts in the wake of 2008 markets crash have indirectly impacted them in a big way. The G20-led efforts to deleverage banks – in the US mainly embodied in the Dodd-Frank Act and still-impending Volcker Rule – and the aim to restrict banks’ trading activities have, possibly, inadvertently increased the internal costs of capital and exerted downward pressure on banks’ capital commitment to holding US corporates in their inventory and to facilitating principal trading (voice or electronic). Today’s end user customers and the buy-side get their US corporates far more from new issues than from fills from the sell-side.
Concurrent with Dodd-Frank’s knock-on effect on sell-side dealer commitment to principal trading, the US Federal Reserve has actively promoted low interest rates effectively down to 0%. This has increased both investor flights to the relative safety of US corporate bonds for their relatively higher yields. Corporate issuance of new debt for refinancing and raising new capital at these new, relatively low rates has increased. It has been a seller’s market, with retail and institutional investor appetite for both high-grade and high-yield consuming US corporate bonds snapping up offerings as quickly as they can be issued. Prices have been bid up and yields driven down. The robust primary market has supplanted the relatively weaker secondary market; in fact, end user customer and buy-side inventory far outweighs sell-side inventory.
The Dodd-Frank Act
Signed into law in 2010 and broadly aimed at taming the OTC derivatives markets, Dodd-Frank’s regulatory efforts, while still very much a work in progress have begun to be implemented this year. While not directed at US corporates, Dodd-Frank’s changes to trade flow and its unintended consequences abound, including the firming up of and increase in collateral requirements. As a result, the types and amounts of assets that US banks can readily hold in inventory will decrease. This has already contributed to US banks’ record low inventory in US corporates in the middle of a bull market.
The Volcker Rule
This US regulation, also stemming from Dodd-Frank but still not finalised, is expected to be implemented later this year. It aims to restrict banks from many kinds of speculative investments, generally banning them from proprietary trading (the major exceptions being in US treasuries; agency and municipal bonds; and traditional market-making) and includes many much-lobbied-for minor exceptions and loopholes.
US corporates are, thus far, not included within the Volcker Rule’s exemptions for proprietary trading bans. Although not finalised, the current prognosis for banks’ dealing activities in US corporates is negative.
- Getting Done – Secondary v New Issuance: In as much as 2012 was a record year for US corporates, with TRACE volume continuing to increase, it’s crystal clear that this was mostly due to new issuance rather than secondary trading. While outstanding US corporate debt has continued its decades-long increase and TRACE volume has increased modestly in line with prior years, new issuance soared 34% over 2011, and 21% over 2007 to an all-time high of US$1.4 trillion. Very clearly, end user customers and the buy-side are getting their fills in US corporates from new issuances, not from the secondary market. Assuming that the 30-year bull market in US corporates continues, will new issues continue to keep up with end user customer and buy-side demand at their current pace? How much debt remains to be refinanced? And assuming that the market turns bearish, where else but in the secondary market will that sell-off take place?
- Getting Done – Dealer Inventories v Agency Business: Amid this boom in US corporates, banks’ inventory has dropped dramatically from prior years. Down 38% from 2011 and 78% from the 2007 highs, it languishes at a near record low level not seen since 2002 – due primarily to regulatory pressure and the resulting increased internal capital costs. Whatever dealing the banks are doing, it is out of a deeply reduced inventory, and there is no sign that this will change. Much more matched principal trading is going on. While not yet engaging in pure agency trading, banks are holding on to dealing inventory for much less time in their dealing activity, from a matter of days to weeks, versus in and out of long-term inventory – banks seem to be getting in and out versus taking long-term positions, and their reported positions bear this out.
The banks’ inventory drop from the peak of 2007 to 2012’s near low is uncorrelated with TRACE volume during this time. Meanwhile, many banks are creating their own electronic platforms (e-platforms) that enable their customers to interact with each other under the auspices of the bank as broker-dealer. Whether motivated by reduced inventory that is unable to satisfy their customers’ trading appetites, or simply by recognising that the inventory now resides with end user customers and the buy-side, some banks are newly embracing e-platforms to get their custom done. With the sell-side unwilling to maintain dealer inventory in a bull market, what is the likelihood they will do so in a bear market? The trends suggest a continued reduction of dealer inventory and an increase of agency trading.
Electronic e-trading v Voice
E-platforms and markets have solidified their presence in the US corporate bond market over the past 11 years of TRACE, but at less than 30% of the market their liquidity has largely plateaued, certainly relative to new issuance. The majority of trading is still mainly done by voice and unstructured electronic messaging (email and chat). Yet current trading conditions do not bode well for sustaining the voice and principal trading traditions of this market. Market structure is in the middle of a tidal change, with electronification set to move rapidly beyond its current plateau and, together with agency trading, to fill the liquidity gap left by decreasing new issuance and diminished sell-side inventory and principal trading.
While numerous retail-oriented electronic platforms abound in US corporates, and some banks’ e-platforms are beginning to proliferate, Bloomberg and MarketAxess have been the main institutional players forming an electronic duopoly, both via request for quotations (RFQs) and lacking live tradable prices.
While the overall US corporates market is soaring, electronification rates clearly are not – at least not yet. Even so, fresh institutional indications of interest in some of the smaller e-platforms, even retail-focused ones, may be a harbinger of more e-trading to come, though thus far that hasn’t translated into more sizable institutional volume traded on them. There have historically been, and continue to be, a number of upstart markets for US corporates, although there seem to be more now than ever, as well as promising conditions for their success.
Where to Next?
US corporates are empirically in a bubble, although when it will pop remains unclear. In a continued bull market, the prevalent direct-to-consumer (D2C) and voice-driven principal trading model will become increasingly unsustainable for even moderate portfolio rebalancing or normal turnover. Should the market turn bearish, new issuance will be of no use and the D2C and voice principal trading model will fail. Under either scenario, new electronic institutional trading models will prevail, the only question being how fast.
While trading of institutional US corporates continues to electronify organically from TRACE’s 2002 inception, the rate of fills via new issuance has considerably outpaced electronification. Last year marked a turning point, with at least four sell-side broker-dealers not only embracing electronification in rolling out new platforms but incorporating a hybrid customer-to-customer (C2C) agency trading mode as well. MarketAxess is well positioned to move from RFQ-only to a central limit order book (CLOB). 2012 will reflect the tidal change in institutional US corporates from a principal-only model to scalable matched principal trading.
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