Concerns grow over mismarked bond positions

IFR 2325 - 21 Mar 2020 - 27 Mar 2020
6 min read
Christopher Whittall

Extreme levels of volatility in credit markets are compromising traders’ ability to mark corporate bond positions accurately, raising further questions about the true value of beaten-down debt markets.

Composite bond pricing services run by trading and data platforms such as Bloomberg, MarketAxess and Tradeweb are struggling to put an accurate value on large sections of credit markets, traders and investors say, as trading desks provide wildly diverging quotes for individual bonds.

On volatile days such as March 9 when oil prices collapsed, MarketAxess said it couldn’t put a pre-trade price on an unusually large proportion of bonds in the energy sector, because the data it received was so volatile and unreliable. Usually, it can put a pre-trade price on 95% of all corporate bonds in the market. More generally, the trading platform’s ability to put an accurate pre-trade price even on high-grade bonds has also diminished in recent weeks.

The mismatch between where bonds are marked and the amount of money they can be exchanged for in practice could have serious consequences for fund managers already faced with mounting redemption requests.

Some traders fear that investors selling bonds will re-price the market (and therefore their own positions) lower, creating a self-reinforcing cycle that encourages even more selling.

“The ability of the market to agree on a price, separate from the trade, is more dispersed than it’s ever been – by quite a lot,” said David Krein, global head of research at MarketAxess.

“The disorder borders on chaos, especially in energy. It’s quite a challenge to see any consistency in liquidity sources from dealers or elsewhere.”

LIQUIDITY CONCERNS

Long-standing concerns over the liquidity of corporate bond markets – or the ease of trading bonds in decent size – have resurfaced in recent weeks as debt prices have collapsed amid the coronavirus pandemic and plunging oil prices.

Traders have reported yawning gaps between where bonds are quoted and the levels at which they actually trade.

Composite pricing services from trading platforms provide an important, neutral resource for traders and investors to value their bond positions fairly. But the quotes from trading desks and data from the wider market that tends to feed into these services have become increasingly volatile during these extreme trading conditions, making it harder to assign securities a fair value.

There is increased uncertainty even in high-grade bonds. MarketAxess’s composite pricing tool will usually formulate a price within a basis point of where most of these bonds trade in yield terms, but these days its composite price tends to be about 3bp off actual trading levels.

In the high-yield space, traders say there are examples of bonds trading five price points – not basis points – lower than the price at which they are being quoted.

“Liquidity is there but it has a price ... [and it’s] different from the screens. Whenever you want to really trade, when you want to sell, bids are far from being what you have on the screen,” said Philippe Berthelot, co-chief investment officer for fixed income at Ostrum Asset Management.

Berthelot said his team had tried to be as fair as possible on valuations, using various different pricing sources, such as taking the lowest prices of some received bids or using index providers, and having a daily calculation of funds’ net asset value.

“When the market has vanished, what is the fairness of your mark?” said Berthelot. “In dislocated markets it’s always tricky to say ‘I’ve got a true price'.”

PRICE DISCOUNT TO NET ASSET VALUE OF ISHARES EURO HIGH YIELD CORPORATE BOND ETF

ETF DISLOCATIONS

Dislocations in fixed-income exchange-traded funds highlight the discrepancies in market valuations. When markets are calm, an ETF’s share price trades more or less in line with its net asset value. But credit ETFs have been trading at steep discounts to NAV during the recent volatility, a sign of the uncertainty over bond prices.

On March 17, for instance, the iShares Euro High-Yield Corporate Bond ETF traded at a –12.4% discount at one point. On Friday morning, the discount momentarily disappeared altogether and the ETF traded at a small premium to NAV amid a broad rally in credit markets.

The discrepancy “is being reflected in these big ETF discounts to NAV. NAVs are reflecting where they are marked and ETFs are telling you where you can sell your bonds and where you can execute”, said one New York-based credit analyst.

Some are concerned that a re-marking of bond positions to reflect more accurately where they can be sold could be a catalyst for a further sell-off. Fund outflows have accelerated in recent weeks, with investors pulling over US$35bn out of US investment-grade credit funds in the week ended March 18, according to Lipper. That is raising the prospect of investors having to sell more bonds, pushing market prices lower still.

“If [investors] try and sell, they hurt themselves because they have to mark positions lower - it’s more painful than taking the volatility,” said one senior credit trader.

“If this were to persist then you’ll get to clearing level marks and below, and people get forced to sell.”

Additional reporting by Eleanor Duncan