When Josh Barrickman turned often known as the brand new “bond king”, his colleagues teased the taciturn fund supervisor by leaving paper crowns from Burger King at his desk.
The low-key Ohio native might not have the excessive profile of bond market stars corresponding to Invoice Gross however he has earned his title. The fund he runs, the Vanguard Total Bond Market, is the world’s largest fastened earnings fund, with $247bn in property beneath administration.
The fund’s table-topping place exemplifies the revolution beneath method within the $9tn US bond market. Not like the freewheeling, actively-managed Complete Return fund as soon as run by Mr Gross, Vanguard’s flagship bond fund is a passive, index-tracking fund. It takes a smaller payment from buyers and tries to trace the market, not beat it.
Exchange traded funds, which additionally attempt to imitate an underlying benchmark however commerce like a inventory, have helped popularise passive investing. In equities they’ve develop into large, however they’re catching on in fastened earnings as nicely. Final yr, the property in passive bond ETFs hit $1tn for the primary time, in accordance with information supplier ETFGI.
Such a radical shift has been facilitated by massive adjustments in buying and selling know-how. Gone are the clunky Telex machines merchants forcefully punched transactions into. Now a whole lot of bond trades could be electronically priced as one and executed concurrently with a single counterparty. This new type of “portfolio trading”has unfold from ETFs, taking maintain throughout Wall Road and dealing its method again to buyers like Mr Barrickman.
“ETFs on the fastened earnings aspect are a very massive deal,” he says. “For fastened earnings that is actually our first exchange-traded, liquid and clear market. They lend themselves completely to the portfolio buying and selling phenomenon.”
It has additionally drawn an entire new class of gamers into the market. Bond buying and selling was as soon as the extremely profitable area of funding banks — from the heyday of Salomon Brothers within the 1980s to Goldman Sachs’ high-octane enterprise of the previous 20 years. However now a brand new technology of lightning-fast, computer-savvy buying and selling corporations is offering various locations for fund managers to commerce.
“We’re on the verge of among the largest adjustments on this panorama for many years,” says Matt King, a strategist at Citi.
Simply over 4 years in the past Matheus Pereira was taking his closing exams on the prestigious Wharton enterprise faculty on the College of Pennsylvania. As we speak, working within the New York workplace of a Dutch high-frequency buying and selling agency, the Brazil native reckons he’s accountable for three per cent of US high-yield bond trading volume. Some days, he says, his agency’s buying and selling accounts for 10 per cent of the market. He’s 28 years outdated.
Mr Pereira’s meteoric rise has been made doable by the shift in direction of passive investing and fixed-income ETFs. He joined his agency, FlowTraders, in July 2015 and took over as head of buying and selling a yr in the past. He has by no means labored at a financial institution and by no means traded with a Telex machine.
Mr Pereira says an absence of familiarity with outdated programs is liberating. He likens the bond market to the “marshmallow problem” created by designer Peter Skillman: a group has to rapidly create the tallest construction they will that may assist a marshmallow, utilizing 20 items of spaghetti, a metre of tape and a chunk of string. Pre-school kids constantly beat enterprise faculty graduates, attorneys and executives.
“They [the children] aren’t serious about the foundations of physics and what’s logical,” he says. “They’re actually simply attempting to think about what works.”
The bond market innovators take an identical strategy. FlowTraders, together with rivals corresponding to Jane Road Capital and Susquehanna Worldwide, makes markets in ETFs, providing buyers a value to purchase or promote shares. In fastened earnings markets, ETFs are created by exchanging a basket of bonds — normally 100 or so — with an ETF supplier for a set variety of ETF shares that may then be traded like a single inventory. Conversely, the shares could be redeemed for the underlying bonds.
By way of this “creation and redemption” course of, market-makers like FlowTraders find yourself buying and selling not simply within the ETF but in addition within the underlying company bond market. As cash poured into ETFs, the amount of buying and selling by the brand new gamers grew.
It laid the inspiration for the rise of portfolio buying and selling, with the power to commerce a number of bonds concurrently taking over a brand new significance, not least for the banks desirous to hoover up the rising enterprise.
But it surely offered challenges. How do merchants assess the worth of a whole lot of particular person bonds and scale back them down to at least one tradeable value? The reply, once more, is thru know-how — harvesting information from regulatory reported bond trades and ETF costs listed on exchanges.
Even earlier than the rise of fastened earnings ETFs in recent times, there was a gradual transfer towards digital bond buying and selling, which has elevated the quantity of public value info. Now, digital platforms like MarketAxess and Tradeweb collectively account for 34 per cent of all higher-rated, funding grade company bond trades.
With extra out there info, buying and selling platforms, together with different information corporations, have begun producing composite, indicative costs for a spread of bonds. Banks and buying and selling corporations have additionally developed their very own fashions to electronically value securities, typically utilizing the third-party costs as an enter.
“The evolution going down in credit score — with ETFs on the centre — is about third-party pricing,” says Jon Klein, head of US funding grade and head of US macro credit score merchandise at Financial institution of America. “There’s a rising consolation to utilizing third occasion costs that’s altering the face of credit score.”
It means an Excel spreadsheet full of tens, and even a whole lot, of various bonds could be priced in minutes. Financial institution of America says it may possibly value a portfolio of 100 bonds in 5 minutes, with even the trickiest trades sometimes priced in beneath one hour. Different banks give comparable timeframes.
Jane Road says the scale of a single portfolio commerce can vary from 10 to 1,000 completely different bonds, including as much as over $1bn. Over the course of 2019 Jane Road accomplished $66bn in credit score portfolio trades, up from simply $12.5bn within the second half of final yr, after they began doing these transactions.
“Portfolio buying and selling was only a very pure extension of the enterprise that we had been doing,” says Matt Berger, head of fastened earnings buying and selling at Jane Road. “It’s not a very new concept, however began changing into a day by day prevalence final yr.”
As banks have responded by constructing out specialised portfolio buying and selling companies, the apply has expanded to different shoppers. Money-strapped fund managers have been attracted by the prospect of buying and selling a slew of bonds directly in an try to chop prices.
“Two years in the past pricing 800 bonds can be an all-hands-on-deck, all-day train. Now it may be achieved in minutes,” says Dan Veiner, world head of fixed-income buying and selling at BlackRock.
The emergence of portfolio buying and selling may even tackle one of many largest monetary stability considerations to emerge over the previous decade.
Historically, when asset managers have suffered investor withdrawals, they’d little alternative however to boost money rapidly by promoting their most liquid bonds. That would push costs decrease and made funds’ portfolios riskier, exacerbating investor fears and driving additional withdrawals.
Final summer time Mark Carney, the Financial institution of England’s governor, instructed a parliamentary committee that funds which promised buyers that they will withdraw cash at any time whereas investing in rarely-traded securities — corresponding to many company bonds — were “built on a lie”, and that the dangers “might be systemic”.
Portfolio buying and selling provides a doable answer. As a substitute of promoting a considerable amount of one bond, an asset supervisor may rapidly promote a small quantity of quite a lot of bonds, with the portfolio they personal afterward wanting very similar to the preliminary one, solely smaller. This might ease considerations over a downward spiral into illiquidity, argues Citi’s Mr King.
“We don’t see this resolving all of the systemic considerations, particularly the place investor herding is worried,” he says. “However at a minimal, we expect this has the potential to revolutionise how particular person portfolio managers take into consideration day-to-day liquidity administration.”
Banks are preventing to sustain with the trade by investing in digital infrastructure. Their sense of urgency is underlined by the truth that most of them declare to be a “market chief” or “innovator” in digital or portfolio buying and selling of bonds.
Some bankers ponder whether what is occurring in bond markets will echo what occurred to equities buying and selling. As that market digitised, the amount of trades skyrocketed, however the revenue margin on every commerce compressed. Increasingly more of the buying and selling earnings went to the handful of corporations with the most important market share. Plain vanilla money buying and selling of equities, versus buying and selling of derivatives or different advanced merchandise, has develop into an unattractive enterprise for the banks and shifted to new gamers.
Bond buying and selling, equally, appears prone to develop into extra of a scale recreation, and complete buying and selling revenue for the trade will fall, say analysts, even because the very largest gamers prosper.
“One factor that everyone knows is that upon getting machines offering the providers, the power to scale capability on the promote aspect over some comparatively quick timeframe is limitless,” says Phil Allison, head of fastened earnings automated buying and selling at Morgan Stanley. “The inevitable final result of that’s undoubtedly some extent of margin compression.”
On the similar time, banks’ stranglehold on the trade is beginning to loosen. High-frequency trading firms that first got here to the banks as prospects are discovering new methods to commerce on digital bond platforms, in some circumstances connecting straight with the banks’ shopper base of asset managers and hedge funds.
Tradeweb noticed quarterly portfolio buying and selling volumes on its platform rise from $2.7bn after it launched the service within the first quarter of 2019, to nearly $14bn within the closing three months of the yr. MarketAxess, the most important US electronic bond trading platform, says one among its high prospects on its new Open Buying and selling venue, the place anybody can commerce with everybody, is Jane Road, highlighting the significance of those new corporations.
Joe Geraci, co-head of unfold merchandise at Citi, says that if high-speed buying and selling corporations proceed to extend their presence in company bond buying and selling, spreads on the most important, most liquid bonds (the important thing constituents of ETFs) will go down. Compressed spreads will in all probability put strain on the profitability of financial institution buying and selling desks. Enterprise fashions will in all probability want to regulate.
There may be some huge cash at stake. Trade insiders say that between a fifth and a 3rd of banks’ “Ficc” (fastened earnings, foreign money, and commodity) buying and selling income comes from company bond buying and selling. And Ficc buying and selling revenues on the high 5 gamers — JPMorgan, Citgroup, Financial institution of America, Goldman Sachs and Morgan Stanley — totalled over $48bn in 2019.
Financial institution shoppers can be pleased if spreads slender — it could imply they had been paying much less to commerce. However some contributors say there are different components to be conscious of.
The appearance of recent know-how brings with it the potential for new dangers. Whereas some bankers profess portfolio buying and selling will make it simpler to purchase and promote even probably the most unloved bonds, others say that these that don’t match neatly into the massive ETFs, significantly these of smaller issuing corporations, may see their debt shunned. If this occurred, it may imply that the bonds would commerce at a reduction, driving up the small corporations’ price of funding.
“We may see a rising bifurcation between securities which can be deliverable in ETF baskets and [those that are] not,” says Mr Geraci.
One other fear is that confidence in third-party pricing may give strategy to complacency. A valuation created from out-of-date or inaccurate information may rapidly develop into cemented out there by unquestioning buying and selling exercise, solely to quickly unravel as soon as found. “There may be the potential for an echo chamber for illiquid bonds,” says Sonali Theisen, head of fastened earnings market construction and digital buying and selling at Financial institution of America.
Lastly, there may be the priority that electronification makes markets weak to sudden bursts of volatility that merchants can’t foresee and wrestle to comprise. “Each digital market has been by some flash crash kind occasion,” says one financial institution govt. “The cycle pace of the computer systems is a lot faster than people.”
Bankers, buying and selling platforms and asset managers say they’ve safeguards to guard themselves however the potential for unexpected glitches stays.
“The excellent news with that’s we’ve got a blueprint of find out how to keep away from that with the fairness market,” says BlackRock’s Mr Veiner.