Bond portfolio trades are low cost as chips. Why?


As we wrote a number of weeks in the past, fastened revenue portfolio buying and selling is turning into A Big Deal. From just about nothing 5 years in the past, it now accounts for 8 per cent of US credit score buying and selling volumes, in keeping with Barclays.

Barclays at present launched one other report exploring why portfolio buying and selling has exploded in recognition recently. Unsurprisingly in a market the place transaction prices can gobble up a number of returns, it largely comes all the way down to prices.

For reference, a portfolio commerce is when banks or buyers commerce an enormous basket of a number of bonds in a single go, moderately than one by one. These portfolios can vary from 10 to 10,000 bonds, for complete values effectively north of $1bn in some circumstances. It’s the fastened revenue equal to buying and selling a piece of the whole S&P 500.

The financial savings will be vital. Jeff Meli, Barclays’ international head of analysis, estimates that portfolio trades reduces transaction prices by 41 per cent for funding grade company debt and 44 per cent for junk bonds, relative to the place it will price CUSIP-by-CUSIP. The scale of the financial savings begs the query: why?

The first apparent reply is that the massive banks doing these trades for investor shoppers are shopping for market share in a scorching space by bidding too aggressively. After all, they are usually for giant priceless shoppers. But Barclays is sceptical of this argument:

We low cost the primary principle primarily based on proof that the advantages of portfolio buying and selling have remained fixed over time, even whereas their quantity has grown dramatically. If sellers have been competing for volumes utilizing this protocol, we’d have anticipated the advantages to develop as extra sellers grew to become concerned.

Here’s their chart exhibiting how the fee financial savings haven’t modified a lot over time.

Barclays reckons two different theories higher clarify why the execution prices of portfolio trades are extra modest: simpler hedging of massive fastened revenue portfolios versus particular person bonds; and the explosion of the ETF ecosystem.

Although it’s simpler to evaluate the riskiness of a single bond than a big jumble of them, the dramatic decline of the single-name credit-default swap market signifies that they’re typically difficult to hedge. Meanwhile, a big diversified portfolio will be hedged with still-vibrant CDS indices, complete return swaps or different derivatives. Barclays:

Of course, the precise hedging methods utilized by buying and selling desks are fairly difficult and certain range throughout sellers and with market situations. But a easy approach to consider ease of hedging is to think about how a lot of the chance of a commerce is systematic (and, thus, simpler to hedge) versus idiosyncratic.

For instance, portfolios which can be all buys or all sells have largely systematic threat, significantly since most portfolio trades have many line gadgets of roughly equal dimension. A combined portfolio (eg, one that’s 50% buys and 50% sells) really has little or no systematic threat; the systematic threat of the lengthy leg offsets that of the quick leg, and solely idiosyncratic threat stays. Therefore, one strategy to take a look at if ease of hedging impacts the pricing of portfolio trades is to check the execution prices of portfolios that blend buys and sells to people who contain solely buys or solely sells.

But the largest driver is what we talked about within the final put up. The emergence and development of an enormous fastened revenue ETF market has unlocked a ton of choices for each asset managers, hedge funds and banks.

Here are two charts we constituted of EPFR Global knowledge, exhibiting how inflows have exploded over the previous decade, and continued regardless of this 12 months’s bond market wobble miserable general belongings a bit, from a peak of over $1.7tn on the finish of final 12 months to a nonetheless chunky $1.6tn at present.

Trading volumes related to ETFs have additionally jumped. At the tip of 2021, 30 per cent of US junk bond buying and selling and 15 per cent of investment-grade bond buying and selling was generated by ETFs, up from 15 per cent and seven per cent respectively in 2020, in keeping with Barclays.

Fixed revenue ETFs allow portfolio buying and selling each due to the creation-redemption course of (sellers can use a broad consultant basket of bonds to create new ETF shares, or redeem shares for a slice of the underlying bonds) and since they make hedging even simpler.

Here’s Barclays’ abstract:

Given the linkages between ETFs and portfolio buying and selling, it’s no shock that the latter has been rising together with the volumes within the kind er. In truth, the continued development of ETFs could also be important to continued development in portfolio trades. Particularly in IG, if the ETF ecosystem is critical for sellers to be prepared to supply good execution on illiquid bonds, the demand from ETFs places a pure certain on the quantity of portfolio buying and selling . . . 

. . . In IG, this ecosystem permits buyers to crowdsource liquidity in illiquid CUSIPs which can be owned by ETFs. Due to the “lifecycle” of liquidity within the IG market, whereby bonds turn into much less liquid as they age, even the liquid sub-indices used as a benchmark by the most important IG ETFs have many very illiquid bonds. As a end result, IG ETFs have vital demand for these CUSIPs. This explains why 49% of IG portfolios seem designed to crowdsource liquidity in some very illiquid bonds. 

This is much less related in HY as a result of the most important ETFs personal fewer illiquid bonds. However, the benefit of hedging materially impacts execution prices in HY portfolio trades. HY portfolios which can be both all buys or all sells have considerably decrease transaction prices than these mixing buys and sells. The former contain largely systematic threat, which is less complicated to hedge; ETF overlap each permits sellers to make use of the create and redeem course of as an outlet for threat, and makes hedging with the ETF much more environment friendly. This explains why 73% of HY portfolio trades are index — like. Ease of hedging has no impact on IG portfolio execution