Canada needs to change its regulatory approach on the trading of corporate bonds. Regulators and major participants believe that the bond market is mostly institutional and over the counter (OTC) and therefore does not require the same transparency levels as the equity markets. But changes in demographics, technology and market structure are pressuring changes in other jurisdictions.
Corporate bonds are an important investment for retail and institutional investors. Corporate bonds offer investors relatively secure (e.g. investment grade bonds) and predictable cash flows compared to equity. Bonds also offer predictable cash flow that is superior to returns on bank deposits. Corporate bonds in particular also provide higher returns than government bonds. In Canada it is essential for retail investors, pension funds and life insurers to have access to corporate bonds to build diversified, efficient risk-return portfolios of predictable and relevant streams of income.
In Canada, retail investors have invested around $535-billion in fixed income securities, $230-billion directly and $305-billion indirectly through fixed income and balanced mutual funds and exchange traded funds. This means Canadians hold 20 per cent of their financial wealth directly and indirectly in fixed income securities, mostly bonds. A report by research firm Investors Economics said that Ontarians hold 7 per cent of their financial wealth directly in bonds, which is a larger proportion than many European countries. Many experts believe the importance of fixed income in a retail portfolio will continue even if interest rates go up. According to Morgan Stanley, ageing demographics will focus investor demand on regular income, capital preservation and lower volatility of returns.
Retail size value traded is relatively very small compared to total value traded but the number of retail size trades is significant. The Investment Industry Regulatory Organization of Canada (IIROC) reported that retail size trades represent a very small percentage of value traded (less than 5 per cent) but an impressive half of the transactions of debt instruments traded, while TABB Group calculates that in the U.S. over 50 per cent of all trades have a value of less than $100,000.
Retail investors have significant indirect exposure to corporate bonds through mutual funds. More than half of fixed income and balanced mutual fund assets were invested in corporate bonds. This means about $200-billion of corporate bonds, representing approximately one-third of total corporate bonds outstanding, are held in mutual funds.
Understanding where bonds are traded in Canada is hard due to a lack of data. IIROC receives weekly information on the value and number of trades for broad categories of fixed income securities from government securities dealers. Based on this information, published quarterly on IIROC's website, corporate bonds are traded differently compared to government bonds.
More than 80 per cent of corporate bond trading occurs between a dealer and institutional investors, retail clients, and investment funds. Investors in corporate bonds are looking for yield, and therefore tend to be purchased directly from dealers acting as agents in the primary market. In the case of Canada government bonds, the dealer trades through a wider set of counterparties, the most important being the interdealer broker platforms (IDBBs and ATS) with a little over a third of the total amount traded. Here the market is more institutional, as Basel III capital requirements for banks, or minimum high credit rating investment requirements for pension funds come into play.
IIROC is in the process of developing a debt surveillance system that would require its dealers to report all debt securities transactions on the day after the settlement date (T+1) for surveillance by IIROC. The data will not be published for the public, however, but will be used internally to review whether traded prices are fair prices.
Due to a lack of post-trade transparency, retail investors and small institutional investors in Canada lack information to measure whether their order was executed at a fair or market price (best execution) and to calculate the mark-up or mark-down on a bond (by looking at the difference between the all-in cost in the trade confirmation statement, and the bond market price at the time). Even large institutional investors have to compare dealers' quotes with their pricing models to determine whether they are getting fair prices.
This lack of transparent post-trade prices also causes price vendors to obtain bond prices from different sources, increasing the chances of "price smoothing." This occurs when portfolios are valued at prices different than market prices, in order to reduce volatility or smooth returns. Price smoothing is possible when there is no public market price available, requiring a fair value calculation that is based on bids or mid-price quotes and, if none is available, use financial models. Some studies in the U.S. have shown that public post-trade transparency reduces the variability among quotes, therefore reducing the possibilities of price smoothing.
A lack of an aggregated, widely publicized price can also potentially increase spreads in stressed markets to an exaggerated degree. Markets move quickly in stress scenarios, therefore dealers will increase the spread further in opaque markets (compared to transparent markets) to protect them against adverse price movements, because due to a lack of an aggregated widely publicized price, they cannot update their information fast enough.
In the U.S. and Europe there is a growing trend towards the use of electronic trading for bonds. One reason is the shrinking influence of dealers (the main obstacle to electronic trading) as the net bond inventory they hold has diminished dramatically, and as a result, they are not providing as much liquidity as before. The second reason is the convergence of the institutional and retail worlds. The average block size on Request for Quotes (RFQ) platforms has been declining year after year. According to MarketAxess's CEO, the per cent of block trades reported to Trade Reporting and Compliance Engine (TRACE), a U.S. mandatory 15-minute delayed to the public trade price reporting mechanism, has shrunk from 55 per cent to 42 per cent in four years.
Smaller sized trades are easier to execute in electronic platforms, because information leakage is irrelevant – unlike in large transactions, where being front run or moving the market price excessively can be very costly for the trader holding the bonds in its inventory. According to TMC Bonds, over 80 per cent of the micro bond market (trade size less than $100,000) is traded electronically in the U.S. The increased use of electronic marketplaces in part shows that despite less capital being deployed, the total secondary market trading volume in the U.S. has recovered to 2007 levels.
In the U.S., there is weekly information available on the primary dealers' (large financial institutions that act as market makers of Federal Government debt) inventory holdings by type of asset. In Canada, IIROC obtains aggregate debt inventory information quarterly from investment dealers. Aggregate debt inventory holdings of Canadian primary dealers (banks) are sent annually to the Office of the Superintendent of Financial Institutions (OSFI). The U.S. data also includes transactions, which better measures the market making trading activity engaged in by primary dealers.
Dealer inventory values give us potential insight into many elements of the market and can help us understand the bond market structure. If bond inventories are lower, this means dealers act less as the principal in each trade and more as an agent. A principal trade is a trade in which the investment dealer (ID) is trading through their own account (they own the asset temporarily), while an agent trade is a trade in which an ID is trading for a customer acting as an intermediary for the account of its customer. When executing trades as principal, the ID typically charges its customer a markup, markdown, while in an agency trade the ID generally charges the customer a commission for its services.
The chart below shows how in Canada, primary dealers' debt inventory holdings have been flat, while mutual funds' debt holdings have doubled in the 2007-2013 period.
SOURCE: OSFI
This means that in Canada dealers are acting more as agents than they were six years ago. This change in market structure translates into a need for higher levels of transparency, as agent trades become more efficient in markets where it is easy to find the other side (i.e. electronic markets). Of course, block trades (trade sizes over $5-million) will still need to be worked through the phone by specialist dealers.
In markets where dealers act more as agents than market makers, transparent electronic marketplaces bring transaction costs (spreads and commissions) down and provide best execution information to retail investors. Lower spreads tend to increase liquidity, reducing stress risks – especially when ETFs see redemptions only and need to sell their bonds in the OTC markets. Finally, in the case of issuers, efficient and liquid secondary markets reduce the risk premium and therefore reduce debt capital costs for companies.
Federico Knaudt has over 15 years experience in the Latin American and Canadian capital markets. He is the former CEO of Latin America's eighth largest stock exchange, and in Canada, he has researched the exempt, junior, ETF and corporate bond markets while working for an alternative trading system as well as for the Ontario Securities Commission.