Corporate bonds: developing the secondary market through electronification

Corporate bonds have become a popular vehicle of investment in recent years.

• In the developed world a key driver of growth has been the low interest rate regime persisting in some markets which has made many companies issue new bonds at a relatively low cost of borrowing. Potential for higher returns from these bonds makes them a lucrative proposition for many investors, particularly institutional investors like pension funds and insurance companies.
• In the emerging markets, buoyed by long term growth opportunities companies 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.
• Buyers of corporate bonds, particularly those in the emerging markets, typically hold on to them till 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 substantially high, especially compared to other asset classes like equities or FX.
• The problem is exacerbated by the lack of standardization among issued bonds. Different corporates issue bonds at different points of time with varying tenors and coupon rates purely based on its specific requirements. Even the bonds issued by the same company at different points of time can have different terms, unlike that seen in case of equities.

These issues limit the choice of investors in the secondary bond market. This gap is typically filled by dealer banks who act as market makers by taking their own positions and buying bonds from sellers or selling them to buyers. However, recent regulations brought in since the crisis of 2008 have made this task of market making very expensive for the dealers banks because of which many of them have significantly reduced their inventories. According to Mark Carney, the governor of the Bank of England, it now takes seven times as long to liquidate bond portfolios compared to what it took in 2008. As some of the central banks consider raising 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. In last 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. Here, dealers will not be the central agents; even two investors can connect to each other through the venue to complete a trade. Following other asset classes like equities and FX where electronic trading has already become popular, entry of such platforms in the bond space would be a logical extension. Further electronification of 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 voice (over the phone) execution method and extent of adoption of electronic trading is relatively limited so far. The structural shifts taking place in this market may finally expedite this process. A number of players have developed or are developing trading platforms; even some of the leading exchanges like the Swiss SIX exchange and the Singapore Exchange are looking to add bond trading platforms. Such trading platforms have the potential to improve price discovery in bond markets and reduce trading costs, boosting investment returns in the sector. A key challenge in this regard 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 investments and know-how of running the operations. 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 adequately should contribute to growing electronification of the market. However, lack of standardisation of issued bonds will still be a challenge and is something that can only be addressed by the issuers, and therefore may take time.