Fixed Income ETFs: Adding Liquidity to the Bond Market (by Kiran Pingali, Bloomberg Tradebook)05.18.2016
This Blog post is Part 1 of a white paper on Fixed Income ETFs. Part 1 has the following subcategories
- The case for Fixed Income investments
- Fixed Income and the Corporate Bond Market
- Liquidity of the Corporate Bond Market
Part 2 which will be published at a later date has the following subcategories
- High Yield Bond ETFs: A Source of Liquidity to the Corporate Bond Market
- Key parameters to look at when trading Fixed Income ETFs
- Tradebook’s ETF RFQ platform for trading Fixed Income ETFs
The case for Fixed Income Investments
The volatility in the equities market in Jan and Feb of this year and the resulting sell-off in risk assets from bank shares to crude oil and emerging market currencies coupled with a rally in major sovereign bond markets has investors talking about investing in Fixed Income instruments. The chart below presents a comparison of return numbers for a portfolio made up entirely of stocks, a portfolio made entirely of bonds and portfolios with blends of both stocks and bonds: As can be seen from the chart, a portfolio comprising of 100% bonds had a positive 1.93% return ytd, compared to a portfolio comprising of 100% equities which had a negative 5.06% return ytd – stressing the importance of diversification and holding bonds in your portfolio.
OTC Fixed Income and Corporate Bond Market
A recent TABB group report on the state of the Fixed Income market points out that over the past eight years, the OTC fixed income market has grown by close to 20%.
A look at the US Corporate Bond market also presents a very positive outlook. Total US Corporate Bonds Notional outstanding has grown steadily and is at $8.1 Trillion – significantly higher than pre-crisis levels.
Liquidity of the Corporate Bond Market
Liquidity in the corporate bond market is considered quite “healthy”. FINRA’s office of the chief economist published a report last December titled “Corporate Bond Liquidity Healthy by Most Measure: FINRA Research”. Additionally a paper published by the NY Fed in October 2015 titled “Has US Corporate Bond Market Liquidity Deteriorated?” came to the conclusion that all vital signs indicate an abundance of liquidity.
TABB Group research, in a report on Bond Liquidity Metrics, suggests that while the overall statistical picture of the marketplace today indicates a liquid, healthy market, evidence of an increasing structural imbalance can be found by looking between the lines. The continued reduction in aggregate balance sheet capacity for the top broker/dealers active in US corporate bonds is directly responsible for the marked loss of immediacy, or on-demand liquidity available to participants. Primary dealer inventories in the wake of the financial crisis, net position levels continue to hover at record lows – “TABB Liquidity Impact Ratio:” the ratio of aggregate balance sheet capacity against total size of the market has dropped nearly 60%, to 1-1.4% from 2.4-3.5%. These changes to the dealer landscape, in step with such significant growth of the US corporate bond market as measured by record-breaking volumes traded and issuance, suggest a significant market structure shift. The traditional model of principal risk-based intermediation is no longer an economic option for banks seeking to maintain acceptable levels of return on capital, writes TABB.
During the fourth quarter of 2015, TABB Group interviewed key US corporate bond market participants across buy-side, sell-side and specialized trade service providers.
Across all segments covered within the survey, participants’ responses reflected dim expectations for liquidity available in the US corporate bond market for 2016. Apart from the threat of a ‘large scale macro crisis,’ the most serious threat that participants identified was the ongoing decline in immediacy (balance sheet) provided by dealers
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