Sal Trani comments : New Players Shake Up High Yield Bonds- FTSE Global Markets

The credit crisis has transformed the high-yield bonds market. High-yield bonds are “the most illiquid of the illiquid” in a notoriously illiquid corporate bond market. The buyside complains about the lack of liquidity, but investors know that in a volatile market electronic execution doesn’t always work in their favour. Neil O’Hara reports

 In days of yore—i.e. more than two years ago—anyone who wanted to trade high-yield bonds would pick up the phone to get a quote from one or more of the major dealers such as Credit Suisse, Morgan Stanley or Goldman Sachs. It was a clubby world dominated by a few big players who often had a near monopoly of the order flow in issues they had brought to market. The dealers had to pay to play—the buyside expected them to commit their capital to facilitate customer trades—but fat bid-offer spreads rewarded them handsomely for their trouble.

 The credit crisis changed all that. Under intense pressure to conserve their dwindling capital, the major dealers were no longer prepared to take on risk they could not immediately lay off on the other side. The demise of Lehman Brothers, the near death of Bear Stearns and the shotgun marriage of Merrill Lynch and Bank of America also disrupted long-standing cosy relationships between dealers and their customers. The combination opened the door to new players, who could compete on an equal footing.

 Regional firms, including Raymond James, Morgan Keegan and Stifel Nicolaus, beefed-up their high-yield businesses, as did second-tier national players, including Cantor Fitzgerald and Jefferies. The latter has been particularly aggressive, hiring traders and sales people from bulge bracket firms in a major expansion that bulked-up its high-yield team to more than 50 professionals. The new environment also attracted boutiques like SAMCO Capital Markets and Libertas that try to match up buyers and sellers but never commit capital to a trade.

 “We saw a shift in liquidity from the bulge bracket to the regional dealers and the smaller brokers where they were speaking to end clients who had an interest in high-yield bonds,” says Jason Lenzo, head of trading, equities and fixed income at Russell Investments. The migration began in mid-2007 and continued through early 2009, although Lenzo has noticed the bulge bracket firms starting to flex their muscles again in the last six months now that their balance sheets have stabilised.

 Market Axess, the leading electronic trading platform for US high-yield bonds, has made inroads, too, although the high-yield bond market remains a bastion of traditional voice-based execution. “There is always a story attached to high-yield bonds,” says Salvatore Trani, executive managing director at BGC, a leading inter-dealer broker. “It’s not a vanilla product like Treasuries or even agencies. They trade by appointment—and you can’t put the story on a screen.” The veteran trader sees no chance that electronic trading will ever displace voice broking in illiquid asset classes like high-yield bonds.

 The crisis shook up the buyside as well as the dealer community, but to nowhere near the same extent. Hedge funds that suffered redemptions have scaled back, while other investors who had not been active in high-yield bonds jumped in to take advantage of what one trader calls “the buying opportunity of a decade” when spreads were at their widest. “People are looking for yield,” says Trani. “They are going into the more esoteric junk bonds. The fallen angels add more flavour because they were at one point decent quality and maybe they will be again.”

 The high-yield market consists of two segments: bonds that were speculative grade at the time they were issued, and crossover bonds, the fallen angels that started out as investment grade but were later downgraded when the issuers fell on hard times. Not surprisingly, the fallen angels trade more actively than original issue high-yield bonds; the issuers are established companies with a wider following than the fledgling upstarts—which may not even have publicly traded equity—that dominate the original issue market.

 Crossover bonds go through a comprehensive change in ownership when they drop below investment grade. They are ejected from standard benchmarks such as the Barclays Aggregate Bond Index—and many investors are not permitted to hold speculative grade bonds under any circumstances. Regulated entities face higher capital charges if they retain these bonds, too. A flurry of activity inevitably follows a downgrade, but the redistributed bonds then settle down to a more sustainable trading pattern.

 Original issue high-yield bonds trade actively for a few weeks after they are issued, but in time they typically migrate to long-term holders and volume dries up. The lead underwriter usually knows better than anyone where the bonds come to rest, which gives that firm a huge advantage in handling subsequent order flow. It becomes the “axe” in the security, privy to the associated story and best placed to locate a natural investor to take the other side of a trade. “The investment bank that brought a bond to market works closely with the issuer,” says Andy Nybo, principal and head of the derivatives practice at TABB Group, a New York-based research and advisory firm that specialises in the financial markets. “It will make a market in the issuer’s bonds not only for profit but also to ensure the relationship persists.”

 Once the bonds find a semi-permanent home, Nybo says it often takes a corporate event to dislodge them: a merger, a bankruptcy filing or a new debt issuance, for example. Under normal circumstances, however, the bonds hardly ever trade, which leaves dealers other than the underwriter little incentive to make a market.

 As a result, these bonds are not well suited to electronic trading, which requires multiple market participants that are willing to quote the majority of the time to create a consistent and accurate market. “Some of these issues are traded so infrequently that there just isn’t a good market,” says Russell’s Lenzo. Although he sees scope for aggregators like Market Axess that allow investors to get quotes from multiple dealers, he expects much of the fixed income market—and high yield in particular—to stick with traditional voice execution.

 A human trader will always be the better bet if an investor wants to buy or sell a big position anyway. If word gets out that a $20m chunk of a $200m bond issue is for sale, all the bids vanish and the trade will go through at a price several points worse than the market quote. “You want to speak directly to someone with whom you have a solid relationship to minimise the information leakage,” says Lenzo. “If you have dealers who are willing to represent the customer’s best interest you can get a very sensitive issue traded with little or no market impact.”

 It’s a different story for small orders, for which voice execution is time consuming and expensive. That’s where Market Axess has discovered fertile ground for its electronic platform, which allows investors to solicit quotes from multiple dealers at the same time. Sandy White, high yield and emerging markets product manager at Market Axess, says that while the average ticket size traded in high yield is smaller than on a typical institutional desk, it has gone up in the past couple of years due to the influx of fallen angels like AIG and CIT Group, which have numerous large bond issues outstanding.

 The squeeze on the major dealers has also helped Market Axess boost its share of trades. “From September 2008 our volumes just took off,” says White. “People were looking for other ways to find liquidity, and we were one of the best tools out there.” Although Market Axess still accounts for less than 5% of secondary market activity in high yield bonds, White says trading volume has grown faster in the last year than in any other sector of the fixed income market that trades on its platform.

 The firm has signed up more than 700 buyside investors, who can now request quotes from 35 high yield bond dealers, a number that doubled in the 12 months after Lehman collapsed, adding a raft of regional and smaller firms. White wonders whether all the new participants will stay in the game for the long haul, however. He expects the major dealers will use their balance sheet strength to win back market share in the next 12 months at the expense of firms that do not commit capital, a view shared by Trani at BGC. Says White: “Risk free orders are going to become harder to come by in the future.”

 To David Easthope, a senior analyst in the securities and investments practice at Celent, a Boston-based financial services research firm, high-yield bonds are “the most illiquid of the illiquid” in a notoriously illiquid corporate bond market. The buyside complains about the lack of liquidity, but investors know that in a volatile market electronic execution doesn’t always work in their favour. “The liquidity is really in the credit default swaps market,” says Easthope. “If a pension fund is looking to trade cash high-yield bonds, the traders are going to pick up the phone and call their best relationships. It is still very much a phone and Bloomberg based system.”

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