The DESK Research: Bond Liquidity for US Mid-Market Buy Side

Fixed income liquidity to become more centralized

In 2022, despite strong secondary trading volumes, many buy-side firms are citing deteriorating liquidity conditions and dealers have seen trading revenues decline in the second half of the year.

Bond market liquidity is traditionally supported by dealers who leverage their balance sheets to buy or sell from their clients and later trade these inventory positions with other clients at a profit.

However, due to the current market structure, regulatory constraints and scale of current activity and interest rate movements, these sell-side firms face constraints in providing supportive liquidity to clients.

There are numerous indicators of stress on market performance. For example, the Federal Open Market Committee (FOMC) began raising target interest rates on March 17, 2022, and in the intervening period, the Corporate Bond Market Distress Index (CMDI) has risen from 0.13 to 0.27, indicating a “change” from the 13th. . According to Federal Reserve economists, the percentage is modestly above the historical average of bond market conditions.

“Looking across different types of corporate bonds by default risk, the high-yield (HY) index remains below the historical median, but the investment-grade (IG) index is in the top quintile, suggesting strained market performance,” they note.

To assess current conditions from a buy-side perspective, DESK spoke to 30 US asset management firms to gauge their liquidity, dealer engagement, data usage and access to e-trading.

Executive summary
In fixed income markets, it is understood that price levels differ between market makers and consumers. To minimize any bar-balling of the results, our survey solicited responses from 30 mid-tier asset managers in the US fixed income market.

We found that most respondents rated their access to liquidity as between moderate and poor. A significant majority report that access to liquidity has either deteriorated or significantly worsened over the past year. This is perhaps not surprising given the well-documented lack of pre-trade transparency, the current rising rate environment and shrinking balance sheets.

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

Most of the respondents agreed that large scale trading is the most difficult objective to achieve. Electronic trading is used more for small trades and rarely (or never) for larger trades including blocks.

In general, alternative routes for pre-trade liquidity analysis and execution of medium to large trades currently offered to traders and managers remain underutilized.

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Survey Results:

Access to liquidity
2022 was a tough year for bond traders. Access to liquidity is cited as a major problem. Only 10% of respondents report that accessing liquidity is easy, more than half (53%) rate it as moderate, and more than a third (37%) report that it is difficult (Fig 1).

Seventy percent of respondents said that access to liquidity has worsened, with 20% indicating that access has worsened a lot. Seventeen percent of firms indicated that they had not experienced a change in liquidity position, but only 7% reported an improvement over the same period (Fig 2).

Liquidity discovery process
The way investors seek liquidity is changing. Electronic corporate bond trading is on the rise, indicating a desire or need to explore new trading protocols as well as sources of liquidity.

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

Further research from Acuiti found that 79% of dealers report that their customers have slightly or significantly increased electronic trading this year.

We found that while most companies have adopted electronic trading, only 12% of respondents reported that they had never used an electronic trading platform before.

Orders of less than US$1 million are frequently or somewhat frequently traded electronically by the majority of respondents. Three-quarters of orders between US$1 – 5 million are traded electronically frequently or somewhat frequently by respondents.

Perhaps surprisingly, larger orders are traded electronically significantly less frequently, with 48% of respondents saying they never use e-trading for orders between US$5 – 10 million and 64% saying they do more than US$10 million. Never use e-trading for orders. Historically, large trades have been the domain of voice/IB trading, while electronic trading lots have been much smaller (Fig 3).

What was not clear was whether the lack of widespread e-trading adoption for blocs was due to the failed attempts of large-scale trading in the past, or if the lack of an e-platform for large-scale trading hindered their ability or interest. .

While the adoption of technology to run small businesses continues to grow, most respondents have yet to incorporate data science into their liquidity search processes. Efforts to use data science to assess liquidity and find natural counterparts appear to be limited pre-trade, with 63% rarely or never using data science in this context. Only 10% of respondents used data science in this way frequently, with 27% using it sometimes (Fig 4).

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Implementation purposes
Fluency can be measured differently depending on the implementation objectives. Size and price are two key factors when determining a bond’s tradability. When asked which objective proved most challenging, 37% said size, 20% said price, and 23% said both size and price. Options were given by 23%, with various dimensions including ‘getting a bid when the market moves’ and ‘high dollar or non-index eligible securities’ (Fig 5).

Who provides liquidity?
Buy-side firms come under increased commercial pressures, including shrinking margins on products and rising costs, so they often need to rationalize their dealer relationships. Banks play a crucial role in executing new trades in primary markets, providing research and market color as well as providing secondary trading.

We looked at the level of engagement between survey respondents and tier 1 dealers and mid-tier dealers. We consulted with participants about how and why they engage with the sell side.

Most respondents interact frequently with Tier 1 dealers, whether for access to new issues or secondary trading of bonds. The level of firms rarely interacting with these dealers – 22% – may represent the level of buy-and-hold activity they engage in, or may also represent the limited coverage they receive from their dealers.

Tier-1 sell-side firms are getting the lion’s share of interactions, with 77% engaging frequently or somewhat frequently. (Fig 6)

Interaction with mid-level dealers is less common, with 40% of asset managers rarely interacting with them. Only 37% reported frequent interactions with these dealers. In discussions with respondents, we found that this was in part due to the more limited and exclusive use of smaller dealers, their reduced dealer lists and the level of primary activity occurring with Tier 1 firms. (Fig 7)

Respondents’ perspectives on engagement
Survey respondents were asked for qualitative suggestions on how they would improve fixed income credit coverage. Their answers fit roughly into five categories: breadth of information provided, relevance of information, gathering information, balance sheet commitment and ability to holistically support dealer-client relationships.

In the first category, respondents said they need a greater breadth of names with broader inventories and more opportunities to show.

They shared concerns about the relevance of information, and examples of desired improvements included the quality of axes, more relevant trade ideas.

Noting the number of screens/interfaces required to access dealer information and the preference for dealers to be more agnostic about where implementation takes place, the need for easier data collection was a challenge for many respondents.

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The desire to see more balance sheet commitment also proved an issue, which has raised concerns across the industry. Dealers report that regulatory hurdles and costs imposed by regulatory capital ratios are major barriers to providing balance sheets for customers.

A final concern was the holistic relationship support clients wanted, with a perceived disconnect between primary capital markets/investment banking and secondary market activity.

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

How can companies improve access?
Based on survey results, most mid-level asset managers have moderate to poor access to liquidity, and the situation is worsening.

Buy-side clients pointed to the provision of pre-trade information, such as pivots — or lack thereof — and balance sheets as leading challenges.

Electronic trading has helped by providing better access to sources of liquidity, but there are still many opportunities in terms of using data science and new technologies for more efficient liquidity discovery from natural counterparts and e-trading.

Large trades are the domain of voice/IB trading, with survey respondents reporting size as their most difficult execution objective.

“Exploring large-scale trading through electronic means could open up new channels for liquidity,” said one buy-side respondent. “That’s incredibly valuable when liquidity in the market is declining more broadly.”

Although e-trading is currently more focused on small trades, new e-protocols for block trading are emerging that can bring new efficiencies to trading large orders.

Despite the rise of data-informed e-trading solutions, data science is currently rarely used to trade with natural counterparts. Data science has the potential to allow more accurate provision of services from dealers to clients, allowing more targeted engagement to minimize information leakage, resulting in more efficient trading for the sell side and buy side.

Conclusion: E-trading and data science are important in the fragment market environment
The fragmented dynamics of the corporate bond market mean that connectivity and information are critical. Effective engagement with dealers in the sell-side community is imperative. The need to execute large orders quickly and efficiently is more pressing than ever.

According to a buy-side respondent, “When traditional methods of connecting to the market are not working, trading desks should consider other ways to find liquidity. It may include better pre-trade analysis, more effective use of electronic trading.

Based on insights from survey respondents, the opportunity to leverage electronic trading tools and data science has only become more pressing given the challenging market environment.



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