With portfolio trades, buy-side firms can greatly improve efficiency and overall outcomes when shifting a portfolio’s strategy.
Portfolio trades are a highly efficient way of putting new cash to work in a way that quickly replicates a fund’s existing strategy.
Portfolio trading improves liquidity as bonds that may be illiquid individually can become more liquid as part of a “bundle.”
Technology tools enable institutional investment managers, bond mutual funds, pension funds, foundations and endowments, insurance companies, and sovereign wealth funds to construct and evaluate portfolio trades in under a day and are helping these buy-side firms to realize the many benefits of portfolio trades.
Anyone who has spent time in the fixed income world knows that buying and selling bonds is not like buying or selling stocks. A quick comparison between the bond and stock markets helps to explain why bond trading is complicated (nothing new here…) – unlike equities, bonds do not trade on exchanges; the bond market has far more issuers and issues; the number and variety of terms and conditions data needed to describe a bond is enormous compared to what is needed for a stock; the analytical measures used in fixed income are simply in a different league, quantitatively, than the metrics used to describe equities, and so on.
This helps to explain why trading bonds is much more challenging and why the old-fashioned approach of arranging trades manually, over the phone, still dominates in the bond world. Although it is inefficient and often frustratingly slow, this hands-on, labor-intensive approach has been the only way to simultaneously arrange all of the trades required to achieve a portfolio-level goal. In addition, large strategy shifts to a portfolio could take months without portfolio trading – trying to raise or lower overall credit quality, sector allocations, or adjusting duration targets.
However, the situation is (finally) changing. Portfolio trades in the corporate bond arena have become increasingly popular with some estimates at 10% of the market. Broker-dealers, sometimes via a third-party bond trading platform, are increasingly receptive to buying or selling bundles or portfolios of bonds, ranging from a fairly small number to 100+ individual issues. Buy-side firms are benefitting as portfolio trades require less manual effort, offer better liquidity, and allow portfolio managers to execute a group of trades over a short period.
As the name suggests, portfolio trading combines multiple bonds into a bundle to be sold or purchased together, as a single package. A buy-side firm chooses the securities it wishes to buy or sell and sends the total order directly to one or more counterparties, or to trading platforms such as MarketAxess or TradeWeb. Depending upon the liquidity of the individual issues, whether they are likely to be included in ETFs, and the total transaction size, the recipient will then quote a price that reflects the value of all of the securities in the portfolio trade.
Market forces are making bond portfolio trading more attractive and more feasible than in the past. The tremendous growth in fixed income ETFs has made portfolio trades more appealing to the sell-side than individual bond trades. Brokers can hedge portfolio trades using ETFs, especially when the portfolio is well diversified, reducing the risk. The broker can use the portfolio of bonds it purchases to create bundles that closely resemble an ETF’s holdings, and then sell them to an authorized participant who will create new ETF shares. Or it can hedge the portfolio by shorting ETFs – which is much easier than shorting individual bonds – while taking the time to identify buyers for the bonds in the bundle.
Ever since the global financial crisis of 2008, brokers have been far less willing to hold bonds in inventory than in the pre-crisis era, as increased capital requirements greatly reduced the profitability of such risk-taking. Banks are reluctant to buy individual bonds that are difficult to hedge, and many of the proprietary trading desks at banks that used to be alternative sources of liquidity are now gone. It is an understatement to say that bond market liquidity has suffered over the past decade or so.
While liquidity has suffered, issuance has boomed. The ultra-low-rate environment of the past 18-24 months has enticed borrowers across the credit spectrum to issue new bonds and the pandemic led corporations to issue more debt to increase cash reserves. In short, the bond world finds itself with an abundance of issues to buy and sell, but few sources of liquidity to facilitate trading. It is as though farmers had bumper harvests of all types of crops, and consumers were hungry and had money to spend, but grocery stores were unwilling to stock their shelves unless they knew products could be sold in 24 hours or less.
In addition to these structural forces, volatility is an additional challenge to liquidity in trading corporate bonds. Sellers are often forced to accept unattractive prices to get an individual trade done when it involves a sector, credit rating, or individual issuer that is out of favor. However, when packaged into portfolio trades, many “unattractive” bonds can find buyers, because there are ETFs that cover all corporate bond sectors as well as the entire quality spectrum. Investment management firms find they can do a portfolio trade, where every bond will get a price, in a single day, instead of having to spread the trade out over multiple days.
Another important contributor to the growth in portfolio trading – recent technology innovations. Technology providers are making it easy for the buy-side to submit portfolio trades, and for the sell-side to respond with quotes for the entire bundle.
Regulations (such as MiFID II) that emphasize post-trade transparency and require investment managers to show proof of best execution, make portfolio trading via technologically innovative platforms even more appealing. Chioma Okoye, a European credit product manager at Tradeweb, explained that on their platform an asset manager can ask up to three dealers to quote a package price for a portfolio. “All quoted prices, for the package and per bond, are shown on Tradeweb, making it easy to prove best execution to clients,” she said. This level of transparency can also help with transaction cost analysis.
One major hurdle for the buy-side though is in aggregating and optimizing the portfolio trades. Constructing a bundle of bonds to sell in a portfolio trade that may consist of anywhere from 10 to 100 bonds (or more) or evaluating a bundle of bonds a dealer is offering to sell as a portfolio trade requires the right technology tools. It’s cumbersome when shifting portfolio strategy, such as extending duration or going down in credit quality to pick up yield. In other words, firms need systems that are set up to do this.
Instead of spending days or weeks working to aggregate a portfolio trade, bond managers are using IMTC’s powerful calculation engine to determine buys and sells for an optimal portfolio in under a day. Portfolio managers can use IMTC to invest a large amount of cash or execute on a strategy shift with ease.
How does IMTC help portfolio managers to execute portfolio trades?
Specify goals for portfolio: Portfolio managers can codify the goals for a portfolio trade using the Targets module, including the ability to set goals as a percent of the overall portfolio or relative to a benchmark. It allows them to take active position bets, such as over- or under-weighting a sector or duration.
Collaborate across the desk: Teams can work on the same scenarios given IMTC’s cloud-based platform and collaborate more effectively on portfolio trades. Multiple team members can specify changes to sector weights, duration, credit quality, curve positioning, and more to achieve desired portfolio results.
Develop buy lists: Analysts can create buy lists based on brokers’ available inventory, recently traded bonds, or approved names that can be used in optimization scenarios. This allows for a more streamlined approach to determining securities to buy and sell in a portfolio trade.
Optimize portfolio accounting for goals: PMs can then determine the best way to achieve the target strategy shift using the Optimization tool, which runs based on an overlying objective (e.g., maximize yield). Turnover can be limited and it can be prevented from selling specific bonds you want to keep. The tool runs hundreds of calculations, instantly, providing an ideal portfolio in one shot. The result is a list of bonds and par values to submit as a portfolio trade to either purchase or sell.
Taken together, these tools save time, generate trade ideas that achieve portfolio-level goals, facilitate collaboration across analysts and PMs, and create executable portfolio trades that are now possible given the growth in portfolio trading. As liquidity improves and better technology solutions become available, portfolio trading is only positioned to grow within fixed income investing.
Technology is only as good as how it is used. IMTC is designed by and for fixed income professionals, empowering them to take action and make decisions quickly and accurately with real-time data and analytics capabilities. It allows you to future-proof your business; driving operational efficiencies, mitigating risk and delivering performance, to ultimately enable business growth. Learn more about IMTC.
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