A More Informed Picture of Market Liquidity In the European Corporate Bond Market

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1 MARKETAXESS ON MARKETAXESS BID-ASK SPREAD INDEX (BASI) A More Informed Picture of Market Liquidity In the European Corporate Bond Market

2 MARKETAXESS ON MARKETAXESS ON is a forum for thought leadership and discussion on the subjects and issues that are shaping the evolution of electronic trading in the credit markets. With internal resources and third party experts, we are developing research, insights and ideas aimed at bringing new levels of innovation, connectivity and efficiency to the MarketAxess community of clients and dealers.

3 The MarketAxess Bid-Ask Spread Index (BASI) A New Way to Measure Market Liquidity in the European Corporate Bond Market INTRODUCTION Regulatory changes are driving important shifts in the credit markets. The incoming Basel III capital requirements are limiting dealers ability to hold risk-weighted assets, such as corporate bonds, restricting their market-making abilities in those instruments, and thus reducing credit market liquidity and turnover. Confronted by the challenge of buying and selling bonds in these difficult markets, where opportunities for real return are scarce and trading costs are increasing, investors are seeking a more informed picture of market liquidity to help identify trading opportunities and reduce their execution costs. The MarketAxess Bid-Ask Spread Index (BASI) was developed to serve this need. EMPOWERING MARKET DATA MarketAxess Research developed the European BASI as a way to quantify European corporate bond market liquidity. This new approach enables a comparison of the prices quoted for actively traded bonds over time. The development of the index was made possible by access to more detailed Eurobond trade data following MarketAxess acquisition of Xtrakter Ltd. in Xtrakter is a leading provider of capital markets data, operational risk management, trade matching and regulatory reporting services to the global securities market. Under the Markets in Financial Instruments Directive (MiFID), Xtrakter is an Approved Reporting Mechanism (ARM) to the UK Financial Conduct Authority (FCA) and other European regulators. In 2013, Xtrakter processed 1.12bn transactions on behalf of its user community and published pricing data on over 69,000 bonds. It processes approximately 65% of fixed income transactions reported to the FCA. As there is currently no consolidated trade tape in Europe that is comparable to FINRA s Trade Reporting Compliance Engine (TRACE) in the United States, many of our investor and dealer clients have expressed interest in data that can increase the transparency of the Euro and Sterling bond markets. This, in addition to the rising demand for more efficient execution, better tools for transaction cost analysis, and new measures of market liquidity led MarketAxess to develop its proprietary index. Today, many of the world s largest asset managers use the BASI as a barometer of transaction costs as well as a snapshot of overall market liquidity.. 2

4 LIQUIDITY AND THE CORPORATE BOND MARKET Liquidity is a measure of the ease with which a bond can be traded and can be approximated by the overall cost of trading the bond. In over-the-counter (OTC) markets such as corporate bonds, the cost of trading is defined primarily by the difference ( spread ) between the price at which a broker-dealer is willing to buy a bond ( bid ) and the price at which it is willing to sell ( ask or offer ) the same bond. In addition to the credit risk associated with holding a particular bond, the bid-ask spread is related to the length of time a broker-dealer believes it will have to hold that bond before selling it. In order to facilitate fixed income trading for its institutional investor clients, a broker-dealer can either act as an agent or as a principal for a trade. An agent-based transaction is effectively risk-free for METHODOLOGY The MarketAxess European BASI tracks all of the bonds with trades reported to Xtrakter over a given time period. The spread difference between buys and sells is calculated for every bond with reported trades, and then an average of the differences is calculated to represent an estimate of the day s aggregate bidoffer spread. the dealer, as it seeks to find the opposite side of an investor-initiated trade and then execute both legs simultaneously, incurring little or no market exposure. Working as an agent, the dealer does not hold the bonds on its balance sheet, freeing it from having to commit capital. However, because of the illiquid nature of the corporate bond market, when on a typical day a relatively small number of bonds trade with any frequency 1, dealers traditionally act as a principal. In a principal-based transaction, the dealer executes a single side of the trade and, in many cases, holds the bonds until the other side of the trade is found at a later date. During this period, the dealer is subject to changes in the market prices of the bonds it holds and will price trades accordingly, thereby passing along a risk premium to the client for effectively renting its balance sheet. As such, the bid-ask spread serves as a proxy for corporate bond market liquidity. A NEW WAY TO MEASURE LIQUIDITY Tracking bid-ask spread movements is straightforward for individual bonds. However, for the purpose of an index, aggregating the bid-ask spread of multiple bonds to accurately represent the market as a whole is challenging. Most fundamentally, which bonds do you select when the majority trade infrequently? How do you weight each bond s bid-ask spread against others? At what frequency do you recalibrate the index? Daily point estimates are then used to calculate an implied index value using a LOWESS-procedure, a commonly used regression modeling method that stands for locally weighted scatterplot smoothing. On days when less than one percent of the constituent group can be priced, the index is not calculated. The approach of the MarketAxess European BASI takes into consideration these and other factors to create an index that accurately tracks overall credit market cycles. CREDIT MARKET CYCLES AND THE BASI The bid-ask spread of a bond fluctuates according to the issue s creditworthiness and changes in market 1 On average, only 18 bonds trade on both sides (i.e. bought and sold) 10 times or more each day, representing just 12% of the overall daily trading volume for U.S. high-grade bonds. (Source: MarketAxess Research) 3

5 volatility. The BASI, as a broad indicator of market liquidity and implied transaction costs, allows us to observe and explore these relationships further. Under normal market conditions, when dealers can use their balance sheets freely to support market making for clients, the bid-ask spread is generally narrower, reflecting both a lower inventory risk for dealers and lower trading costs for investors. However, during periods of increased volatility, dealers tend to buy at lower prices and sell at higher prices, and bid-ask spreads tend to widen reflecting the increased risk and transaction costs. HISTORICAL BID-ASK SPREADS The MarketAxess BASI typically reflects broader credit market cycles. When looking at historical bid-ask spread data, there is a fairly clear correlation between the index and specific events or periods where risk-taking by dealers and investors has been impacted. For example during the credit sell-off in the early summer of 2013 the European BASI widened out reflecting greater price volatility in the market. We can also use the European BASI to compare transaction costs across markets. The Euro high-grade (HG) BASI is tighter than the Euro high yield (HY) BASI indicating that as expected trading costs in the HY market are higher than the HG market. A similar pattern can be observed in the sterling market. Interestingly you can also compare across markets and currencies, for example to see how much lower trading costs are in Sterling denominated HG bonds as opposed to Euro denominated HY bonds. ADDITIONAL APPLICATIONS OF THE BASI The MarketAxess BASI can be created for specific market sectors, trade size categories and credit products, including U.S. high-grade bonds (USHG), HY bonds, emerging markets bonds and most recently euro and sterling-denominated corporate bonds. The index can also be calculated on a daily, weekly, monthly or quarterly basis. The European BASI helps market participants identify pockets of liquidity where opportunities to trade bonds more efficiently and at lower costs might be revealed. THE EUROPEAN BASI The European BASI has been calculated for both euro and sterling corporate bonds, in high-grade and high yield. By comparing the two currencies we can see, for example, that the euro BASI is much tighter than the sterling BASI, reflecting a larger market in euro-denominated bonds and comparatively better liquidity. 4

6 /5/2001 3/5/2002 3/5/2003 3/5/2004 3/5/2005 BASI (based on MarketAxess trade data) 3/5/2006 3/5/2007 3/5/2008 3/5/2009 3/5/2010 3/5/2011 3/5/2012 MarketAxess BASI (based on TRACE data) THE BASI AND E-TRADING The chart shows two variations of the MarketAxess USHG BASI, for which we have data going back several years. The BASI chart in gold dating back to 2001 is plotted using MarketAxess trade data and represents the average bid-ask spread just for electronic trades on the MarketAxess platform over the period. The BASI chart in blue, starting in 2008, is compiled from TRACE data and represents the average bid-ask spread in the market as a whole. The difference between the two charts is equivalent to the difference in bid-ask spread achieved through electronic trading compared to the spread in the overall market. It is clear by comparing these two indices that consistently tighter bid-ask spreads are achieved when trading electronically. IN SUMMARY Given market structure changes brought about by regulations and a market environment where opportunities to improve yield are scarce, institutional investors are more challenged than ever to actively manage their bond portfolios. According to MarketAxess Research, liquidity is concentrating around a relatively small number of more recent benchmark issues, or large new issues from well-known companies. These bonds tend to be more liquid, trading with greater frequency and tighter bid-ask spreads. Investors wanting to trade bonds that fall outside of this category, however, face a market that is less liquid and highly fragmented, where transaction costs can represent a greater percentage of their real returns. In such an environment, a new way to measure market liquidity is welcome. The MarketAxess BASI offers institutional investors a more informed picture of overall market liquidity. The BASI can also serve as an important tool in an overall strategy to help drive trading and cost improvement strategies. The MarketAxess BASI is available at: 5

7 For more information, please contact: Alex Sedgwick Head of Research Visit our website: marketaxess.com/research/basi

8 2014 MarketAxess Holdings Inc. (the Company ). Confidential and proprietary information of the Company. None of the information contained herein may be excerpted, copied, disseminated or otherwise disclosed to any other person without the Company s express written consent. MarketAxess Corporation, member FINRA and SIPC. MarketAxess Europe Ltd. and Xtrakter Ltd. are regulated by the Financial Conduct Authority.