Bond Trade That’s Gone From Zero to $88 Billion in Two Years
Peter Chalif traces his early days at Citigroup Inc. to a time when trading a large basket of bonds involved hours of work with pen and paper. Now he’s running a team that can accomplish the same feat in seconds.
Chalif credits much of the change to technology-enabled portfolio trading, which is bringing the same blazing speeds to the bond market that stock traders take for granted. Banks are hoping the strategy will help them grab a bigger slice of a shrinking fixed-income pie even as it bites into the industry’s profit margins.
Wall Street’s bond desks have executed at least $88 billion such trades this year, according to an analysis by Morgan Stanley. That’s compared with virtually none two years ago. At Citigroup, the bank says it’s handled multiple portfolio trades topping $1 billion since debuting the technology this year, and it regularly trades blocks of bonds in the range of $200 million to $500 million.
In the early 2000s, “the head trader was manually compiling what each bond was worth and summing them at the end -- it was incredibly manual,” said Chalif, who’s now co-head of beta, electronic and algorithmic trading in Citigroup’s global spread-products unit. “Clients are now embracing portfolio trading, e-trading and other technologies, and they’re starting to get excited about what they can accomplish.”
It’s not just volumes on the rise. Industry revenue from portfolio trading, which was pioneered by Goldman Sachs Group Inc., is expected to reach $400 million this year, compared with $150 million to $200 million last year, according to Amrit Shahani, research director at the banking consultancy Coalition.
The rise of portfolio trading “has been a natural progression for bond markets,” said Jim DeMare, co-head of fixed-income trading at Bank of America Corp. The company said it has multiple full-time staff dedicated to the business, compared with just one 18 months ago. It’s asked to price as many as 11 U.S. corporate bond-portfolio trades a day. Most are between $100 million and $200 million, but some reach as high as several billion dollars, according to the bank.
What’s making it all possible is the rise of credit exchange-traded funds. Historically, hedge funds facing a client redemption might look to sell a large block of a single bond or a one-of-a-kind basket of bonds. The first option could leave them with a portfolio that was out of balance. The second was a problem for dealers, who could have trouble pricing the risks associated with unique compilations. Now, as long as the seller creates a list of securities that matches the needs of the ETFs, the dealers can find eager buyers.
“Ask for a bid on a custom basket, and you have something which is no better than the sum of its parts, and might even be worse,” Citigroup credit strategists led by Matt King said in a recent report. “Ask for a bid on a basket which replicates an ETF, on the other hand, and the mathematics are transformed.”
The ETFs help in two key respects: First, ETFs publish the names and valuations of their holdings every day, providing independent prices for thousands of bonds that both banks and investors can use to value their portfolios. Second, ETFs are able to expand or contract to meet investor appetite by taking in or giving out securities. That means banks can use ETFs to source and offload bonds, making managing their inventory more efficient.
In a sign of portfolio trading’s increased importance to Goldman Sachs, the trader spearheading the effort for the firm, William Wolcott, was promoted to managing director in a move that takes effect Jan. 1.
Industry prognosticators have been warning bond traders for years that these kinds of changes were afoot -- it was always just a few years away, they would say, before fixed-income would look more like the equity business. But with tectonic shifts in credit over the past two years, including the widespread adoption of portfolio trading and the increased availability of prices, hardened fixed-income pros are starting to think the future is now.
“The rate of change in the bond market in the last few years has been stunning,” said Stephen Laipply, head of U.S. iShares fixed-income ETFs at BlackRock Inc. For a long time, “fixed income seemed to be like 10 years behind equities,” he said. “Maybe that’s collapsing.”
Also collapsing: margins. Executives across Wall Street are bracing for fixed-income trading spreads to begin the same slow, steady contraction that’s already taken place in equities trading.
“It’s a similar progression as you saw, to some extent, in the equities space,” said Joe Geraci, co-head of the global spread-products unit at Citigroup. “If you look at what happened to Street profitability in cash equity trading, it’s generally gone down,” he said, adding that “that’s the natural consequence of the marketplace digitizing.”
With tighter spreads and lower revenue, job cuts are inevitable. Those reductions will add to the hundreds of positions eliminated this year by banks including Citigroup, Deutsche Bank AG, HSBC Holdings Plc and Societe Generale SA.
“Instead of having 20 traders try to move 25 small line items each, let’s have one algorithmic functionality move some of those line items for us, in order to allow our traders to focus on what they do best -- which is talking to clients, talking to their research analysts, managing risk, digging deep on their credits,” said Drew Mogavero, co-head of U.S. credit trading at Barclays Plc.
Changes are coming to volume and frequency levels as well. On any given day, 70% of corporate bond market trades are valued at $100,000 or less, and more than 80% of investors find trades above $15 million to be “very difficult” to execute, according to data from Greenwich Associates. When more banks and asset managers start packaging hundreds of securities fit for portfolio trading with ETFs, those numbers are expected to jump substantially.
“The next phase of our tech journey is about competing for flow in an increasingly electrified world,” Mogavero said. “That’s where we’re starting to focus our dollars and our energy.”
By Jennifer Surane and Matthew Leising for Bloomberg: https://www.bloomberg.com/news/articles/2019-11-18/the-bond-trade-that-s-gone-from-zero-to-88-billion-in-two-years