The rise of electronic trading and growing popularity of portfolio trading has had an unintended consequence for the US corporate bond market: making private credit even more attractive.
Portfolio trading, where investors can buy or sell a group of bonds in one or just a few transactions, often via exchange-traded funds, has grown to account for nearly a tenth of the trading volume in the market. That’s helped boost liquidity, which has, in turn, flattened the extra yield that investors get for holding bonds that trade infrequently.
The measure, known as the liquidity risk premium, was worth just 5% of the compensation that investors demand for investment-grade bonds as a whole at the end of last year, compared with as much as 30% a decade ago, according to Barclays Plc data. The British bank’s strategists say this vanishing reward has been a tailwind pushing buy-and-hold type investors like insurers and pensions into the private debt markets.
“That’s a big driver — maybe the biggest driver — right now, from the continued demand from that community for private credit,” Barclays’ global head of credit research, Jeff Meli, said in an interview. “They don’t need the liquidity in public markets and the yield reflects the increased liquidity.”
The topic of shrinking compensation for buying and holding bonds came up at the Milken Global Institute Conference last week. For instance, Jean Hsu, managing investment director of private debt at CalPERS, said the pension firm is growing its exposure to non-public assets to 30-40% of its portfolio from 20% previously.
“The illiquidity premium is driving us to allocate to the alternative areas, like all the privates,” Hsu said.
ETFs are not the only option for bond fund managers, and most trading by dollar volume is still performed over-the-counter by calling or messaging contacts at broker-dealers. Those relationships cannot be underestimated, especially during times of market stress, said Sinjin Bowron, portfolio manager at Beach Point Capital.
“It remains to be seen whether the current liquidity environment will persist if we get into a material spread-widening situation or credit-freeze situations,” Bowron said. “It’s unclear whether the liquidity premium won’t re-inflate when you have net outflows from the asset class.”
Of course, private markets have their fair share of detractors, who argue the asset class comes with trade-offs of its own. For one, there is less liquidity, and private credit may offer little extra in returns over public markets because of enormous inflows.
There are reasons investors have pursued these strategies beyond innovations in market structure. For years, investors had little choice but to allocate to alternative investments due to rock-bottom interest rates and few compelling ideas in traditional credit markets. Private-credit fundraising and deployment has more than doubled over the past five years to $1.7 trillion by the second half of 2023, according to Barclays data.
That trend coincides with the explosive growth of credit ETFs, which can be highly liquid. At least three dozen credit ETFs launched this year, on top of the 110 that did in 2013, data compiled by Bloomberg Intelligence’s Athanasios Psarofagis show. They have about $340 billion in assets with an average trading volume of around $150 billion per month, according to the most recent BI data. Barclays estimates that as much as 25% of total corporate bond cash volumes are now generated by these ETFs.
Rather than having to track down individual bonds or loans with certain types of risk exposures, investors can simply choose an ETF that focuses on, say, US investment-grade corporate credit or emerging-market bonds. Allowing buyers and sellers to target specialized risk that way makes the whole process more efficient, Eddie Wen, global head of digital markets at JPMorgan Chase & Co., said at the Bloomberg Sell-Side Leaders Forum last week.
“The ETF is a really a game-changer for electronic trading in credit because effectively it culminates a lot of the risk characteristics into buckets,” said Wen.
The growing liquidity has also made credit markets more accessible to a wider range of investors.
Take Man Numeric, a quant investment arm of Man Group Plc, the world’s largest publicly listed hedge-fund manager. The firm has been executing 90% of its high-yield and investment-grade trades through digital platforms and expects to get to 100% by next year, said Robert Lam, the firm’s co-head of credit.
Although corporate credit remains challenging for quant strategies, he expects it to grow as more products become liquid through electronification.
“Strategies that rely on harvesting an illiquidity premium will suffer over the coming years,” Lam predicted. “This market dynamic will push the opportunity set towards strategies that can exploit the increasing breadth and depth of liquidity in the public credit market or strategies that can go less liquid, like private credit.”
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