A More Informed Picture of Market Liquidity In the U.S. Corporate Bond Market

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

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.

The MarketAxess Bid-Ask Spread Index (BASI) A New Way to Measure Market Liquidity in the U.S. 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 MarketAxess BASI as a way to quantify U.S. corporate bond market liquidity. This new approach enables a comparison of the prices where the most actively traded bonds are bought and sold over time. The development of the index was made possible by ever improving market data and driven by investor demand to realize greater trading efficiency. In 2002, the Financial Industry Regulatory Authority (FINRA) established the TRACE (Trade Reporting and Compliance Engine) consolidated trade tape for corporate bonds, for the first time shedding light on the prices at which bonds trade throughout the day. FINRA enhanced the tape in 2008 by adding buy and sell indicators for TRACE-reported trades, further improving price transparency. This enhancement also allowed for deeper levels of analysis to be performed on bond market flows and trading costs. Meanwhile, as institutional investors and broker-dealers have continued their search for ways to increase trading efficiency and reduce transaction costs, electronic trading grew to represent over 13% of the overall U.S. high-grade corporate bond market by the end of 2012. 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

METHODOLOGY The MarketAxess BASI tracks a subset of 1,000 bonds selected on a quarterly basis that represent the most actively traded issues, as determined by a rank ordering process. The ranking is based on the number of times the bond has traded over several discrete time periods: the last year; each of the last 2 semi-annual periods; each of the last 4 quarters; and each of the last 12 months. The constituent bonds are exclusively institutional in trade size with a spread lower than 500 basis points in order to minimize outliers. For each constituent bond, the volume weighted average spread (VWAS) is calculated for investor-initiated buys or sells. The calculations exclude any bond not having a trade on both sides of the market, which indicates insufficient liquidity. The spread difference between buys and sells is calculated for every bond, and then an average of the differences is calculated to represent an estimate of the day s aggregate bid-offer spread. 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. 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 the dealer, as it seeks to find the opposite side of an investor clientinitiated 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 bidask 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? The approach of the MarketAxess BASI takes into consideration these and other factors to create an index that accurately tracks overall credit market cycles. In addition, the methodology (see left) can be applied by market participants in a variety of other ways. 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

CREDIT MARKET CYCLES AND THE BASI The bid-ask spread of a bond fluctuates according to the issue s creditworthiness and changes in market 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, the dramatic widening of the high-grade BASI in the middle of 2011 was driven primarily by the European sovereign debt crisis spilling over into the global corporate debt market. The chart shows two versions of the BASI. Since TRACE buy and sell data was only available starting in 2008, MarketAxess Research also applied the BASI methodology to historical trades executed over the MarketAxess trading platform from 2002-2012. The MarketAxess BASI also allows us to view the longer term trend. Although more recent bidask spreads have been narrow relative to the credit crisis peak, we can see that spreads remain at approximately twice the levels seen from 2003 2006, prior to the credit crisis. 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, high yield bonds and emerging markets bonds. The index can also be calculated on a daily, weekly, monthly or quarterly basis. Used in conjunction with TRACE net flow reports, the BASI helps market participants identify pockets of liquidity where opportunities to trade bonds more efficiently and at lower costs might be revealed. 45 40 35 30 25 20 15 10 5 0 3/5/2001 3/5/2002 3/5/2003 3/5/2004 3/5/2005 3/5/2006 BASI (based on MarketAxess trade data) 3/5/2007 3/5/2008 3/5/2009 3/5/2010 3/5/2011 BASI (based on TRACE data) 3/5/2012 THE BASI AND E-TRADING The chart shows two variations of the MarketAxess BASI. 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. 4

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 High-Grade BASI is available at: www.marketaxess.com/research/basi For more information, please contact: Alex Sedgwick Head of Research +1.212.813.6078 Visit our website: www.marketaxess.com/research/basi 5

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