Industry viewpoint: State Street Global Advisors SPDR® and MarketAxess
The success of ETFs in supporting bond market liquidity has been marred by a gap in index construction, until now. These are the findings in a recent whitepaper by State Street Global Advisors SPDR® ETFs and MarketAxess.
Within bond markets, exchange traded funds (ETFs) have played an outsized and to some, a surprising role. The use of ETFs which track indexes of investment grade and high yield corporate bonds (credit) has given investors access to liquidity which would otherwise be untapped, thanks to the contrast in the liquidity profile between corporate bonds and exchange traded funds. At the same time market makers have facilitated greater pricing transparency and availability by using the creation/redemption process for ETFs to price the component bonds.
This has been effective in both high yield (HY) as well as investment grade (IG) markets, despite the typical difference in bid/ask spread and trading volume between HY and IG.
However, there have been issues. The most significant are in those ETFs labelled ‘liquid’, which can still include over 1,000 bonds, they will contain illiquid tails of bonds that make pricing, sourcing and hedging more difficult.
This also makes it much harder to manage the tracking between the credit ETFs — which don’t need to buy every bond in the index — and their indices. ETF asset managers employ techniques to manage tracking, such as using sampling strategies, in which a high percentage of the bonds are bought, but a significant percentage of the portfolio is invested in other instruments such as futures, options and swaps, which are used to replicate the index’s performance. While this has reduced tracking error, it also adds complexity to the ETF create and redeem process, leading to reduced opportunities for arbitrage and increasing the difference between the net asset value (NAV) and where the ETF is trading.
At the start of the COVID-19 crisis in 2020, fixed income ETFs had helped to provide reliable indicators of market prices and had thus supported market liquidity in times of stress. The contribution to liquidity in non-stressed times is also significant. Trading volumes in credit ETFs in the first three months of 2022 equated to over one quarter of the notional volume traded in the underlying bond market.
However, during the bonds market turmoil in March 2020, the differential that exists in liquidity was brought to the fore. Fixed income ETF prices proved to be leading indicators of price movements, as liquidity in some of the underlying bonds dried up. That led to a dislocation between the price for the ETF and the NAV of the underlying index pricing.
In the spring of 2021, State Street Global Advisors polled over 300 institutional investors on the factors driving their increase in allocations to fixed income ETFs and the responses illustrated that transparency, liquidity, and tradability are all critical drivers of ETF adoption.
For those investors prioritising liquidity, incorporating some of the benefits of electronic trading and increased data capture, indices with a greater liquidity focus could prove beneficial, by increasing transparency and leading to lower premiums and discounts for the products that track them.
To support those investors, MarketAxess has created a new index, the MarketAxess US Investment Grade 400 Corporate Bond Index.
It is the first US corporate bond index to use liquidity as the primary index construction criterion. This index was created to eliminate the illiquid tails as well as to ensure that the index constituents are bonds of higher relative liquidity.
Its construction is designed to allow portfolio managers to track the underlying market, much like a broader index, while allowing the execution desk to easily hedge with little or no basis risk, much like an index credit default swap.
MarketAxess has been able to make this work through its existing pricing and liquidity tools. The first of these is the Relative Liquidity Score (RLS), which quantifies the liquidity of a bond relative to other securities. The model used is calculated from actual transaction data and covers nearly 32,000 bonds daily, scoring each instrument on a scale of one (least liquid) — to ten.
The firm’s Composite+ tool pre-trade pricing engine uses machine learning to update bond prices every 15–60 seconds, covering 90–95% of global trading activity in its markets. It provides a two-way and mid-market price for over 32,000 bonds daily, with three distinct sources of bond trading data: earlier Trade Reporting and Compliance Engine (TRACE) prints; indicative bond price data streamed by dealers; and request for quote (RFQ) responses sent by liquidity providers via the MarketAxess trading platform, including responses from the global, open trading all-to-all trading network. Not only does MarketAxess see all executed trades, but it also sees inquiries that never materialise into completed trades.
Underpinned by these tools to provide transparency into market supply, demand and pricing dynamics, MarketAxess can provide both actionable bond prices as well as liquidity scores that can help not only traders, but also portfolio managers as they select the right securities to implement their investment strategy.
This means an index, and any product benchmarked to it, can be priced in real time. Underpinned by intelligent data and analytics, the way the index measures the liquidity of a constituent bond is fairly straightforward.
Firstly the index checks the liquidity score of the bond, using RLS. The MarketAxess 400 US IG Corporate Bond Index only takes bonds with a score of seven or higher. A higher RLS means not only a higher response and hit rate on request for quotes (RFQs), but also a tighter bid-ask spread, as measured by Composite+.
Secondly, the index further screens the availability of real-time pricing for the bond, using Composite+. A bond must have a real-time, two-sided Composite+ price to be included in the index.
The liquidity and price discovery features of the MarketAxess US IG 400 Corporate Bond Index mean that an ETF built to track the index should be able to offer improved price transparency and increased tradability alongside other related fixed income assets.
It should also offer enhanced efficiency in the ETF creation/redemption process — delivering benefit to liquidity providers and investors by delivering tighter intraday pricing, closely linked to real bond values and achievable real-time NAV.
Consequently, a fund based on this index could be used in a number of exciting use cases for investors — ranging from a tactical trading tool to adjust credit and risk, to providing a relative value trading vehicle, mitigating the existing risks noted above.