Something strange happened last month as stocks around the world went haywire: In the United States, the $8-trillion (U.S.) corporate bond market worked just fine.
Credit traders found themselves on an island of relative calm while warring computer algorithms bedevilled equities. Company notes in the United States lost just 0.9 per cent in August, with just a 1.8-cent swing in average prices. Stocks, on the other hand, swung violently, with the Standard & Poor's 500 index plunging the most since 2011 and then surging the most since that same year. They ended August with the worst monthly loss in three years.
The contrast was surprising because much of Wall Street has spent the past five years worrying that a fissure in credit trading would lead to another seizure of financial markets. This time around, corporate debt may have benefited from its idiosyncratic, slower, over-the-counter process. It may also prove to be a better barometer of overall investor sentiment than helter-skelter equities.
Company bonds are governed by thousands of deal documents and traded in phone calls and e-mails. Some trade rarely; others not at all.
That's not an easy recipe for high-frequency trading. So the nanosecond set doesn't really bother with this market, allowing it to retain its oh-so-human inefficiency, at least when compared with stock trading, which is rapidly becoming dominated by algorithms.
That same inefficiency has deeply frustrated many credit fund managers in the past few years as they receive an unprecedented flood of money from individual investors and pension funds. They have had to worry about acquiring bonds quickly enough during rallies and selling them fast enough in the downturn of sentiment, when these buyers may flee.
But the positive side is that investors are forced to think before they buy or sell a corporate bond rather than simply following a computer program.
In fact, bond investors may be starting to find a healthy balance with their computers. While Wall Street banks have curtailed the money and staff they devote to facilitating these trades, a growing number of investors are turning to electronic marketplaces to find other humans to buy their holdings.
Corporate-bond trading volumes on MarketAxess Holdings Inc.'s electronic system surged 49 per cent in August compared with those in the period a year earlier, even as overall trading in the market rose just 15 per cent, according to data compiled by the Financial Industry Regulatory Authority.
Computer marketplaces still account for a small fraction of overall activity in credit markets, and humans have to be on either side of each trade. Investors are still worried about being unable to manoeuvre in a credit seizure.
But on the margins, electronic trading is adding efficiency to corporate-debt transactions without the excess, allowing credit markets to offer a clearer picture of the broader markets. And while debt traders are signalling that there may be more instability ahead, they are not indicating a free fall akin to 2008.
There are real concerns, such as China's slowing economy and potential near-term deflation in Europe, but they're somewhat offset by a generally improving U.S. economy and continuing easy-money central-bank policies worldwide.
In another bout of topsy-turvy trading, investors would be wise to check out credit markets. They're more likely to offer a valid assessment of investor sentiment, not just a reflection of computers gone wild.