The cost of trading corporate bonds remains more than double what it was before the coronavirus-induced slump in financial markets, a sign that conditions in credit markets remain strained despite a recent rally.
The average gap between where traders will buy and sell US high-grade corporate debt, commonly known as the bid-ask spread, jumped more than sevenfold to 18.25bp at the height of the sell-off in March, according to bond trading platform MarketAxess. The spread has since subsided to 5.89bp, but that’s still well above the average of 2.49bp in early February.
Bid-ask spreads also remain far wider in US high-yield debt as well as in European bonds and US dollar-denominated emerging markets securities, a natural consequence of the still elevated levels of market volatility and uncertainty, traders say.
That presents a dilemma to investors with money to put to work in bond markets: stomach higher transaction costs when bargain-hunting in secondary markets, or buy new debt in primary markets where the breadth of opportunities may be more limited.
“We don’t seem to be heading back to where we were in bid-ask spread terms, meaning it will be more expensive to trade these markets,” said David Krein, global head of research at MarketAxess.
“That cost is an interesting wake-up call for asset managers given the low yield environment we had been in [and] given the competitive fee pressures with passive investing. Their trading costs just doubled or tripled in the period of a few weeks. That's a tough one."
STIMULUS SUPPORT
Corporate bond prices have recovered from their lows reached at the height of the coronavirus crisis in March, helped by a series of stimulus measures from the US Federal Reserve and other central banks aimed at supporting bond markets. The extra yield investors demand to hold US investment-grade corporate bonds over safe government debt has declined from its March peak of more than four percentage points to roughly 2.2 percentage points, according to the ICE BofA US Corporate Index.
Money has also begun pouring back into bond funds after investors pulled an unprecedented US$265bn out of fixed-income funds in March, according to Lipper data. US high-yield funds attracted inflows of nearly US$10bn in the space of two weeks after the Fed signalled it could buy high-yield credit, while nearly US$8bn returned to US investment-grade funds.
But trading conditions remain febrile, investors and bankers say, with increased bid-ask spreads reflecting the greater difficulty in putting an accurate price on corporate debt. Even bank trading desks – which ordinarily might be expected to profit from the higher margins on offer – are wary of getting blindsided by a sudden market move.
One banker highlighted a 17% jump in the price of Europcar’s bonds in one day following reports that the rental car company would receive state aid.
“If you’re making a market in that name, that would have been pretty painful,” the banker said. “Nothing is trading on fundamentals.”
Still, record primary market issuance in March and April for US high-grade bonds has allowed some investors to ignore secondary markets altogether.
“We are focusing mainly in primary – it is big enough to fulfil our needs,” said David Arnaud, senior fund manager of fixed income at Canada Life. “The problem with secondary is that it’s very dysfunctional on the bid side.”
RECORD VOLUMES
There is still a good deal of trading going on, though, suggesting some investors are willing to pay up to shift positions. Average daily volumes of US high-grade corporate bonds hit a fresh record of US$35.5bn in April, a roughly 8% rise from March’s all-time high, according to data from MarketAxess.
Andrey Kuznetsov, a senior credit portfolio manager at Federated Hermes, said he has largely been buying in secondary markets, particularly early on in the sell-off when market moves were more driven by poor liquidity rather than company fundamentals.
“You have to be more creative in terms of the way that you trade this environment,” he said. “It’s about having different options in terms of your buys and sells that you’re trying to achieve ... and balancing that against trading costs and liquidity.”
Kuznetsov acknowledged it is easier to buy in large size in primary markets, but secondary markets offer other benefits such as the opportunity to buy bonds at discounted cash prices to face value, as opposed to at par in primary markets. That can lead to greater upside returns as bonds converge to issue price as they approach maturity.
“We operate in an asymmetric asset class in terms of downside and upside [risk]. Being able to capture as much as possible of the upside in the current [environment] is important,” he said.
Additional reporting by Alex Chambers and Eleanor Duncan.