The rise and future of credit portfolio trading

It’s a credit strategy that was off the radar several years ago but now accounts for an estimated seven to eight per cent of the USD 11 trillion corporate bond market in the US.

Portfolio trading, more popular in the US than in Europe, and seldom used in Asia, is closely linked to the Exchange Trade Fund ecosystem and on the rise.

Tighter regulations after the 2007-9 global financial crisis, blossoming technological solutions, and new market entrants have shaken up traditional markets like fixed income.

This article will see who benefits from the trading protocol and what the future might hold. But first, let’s look at the basics and background.

What is portfolio trading?

Portfolio trading involves trading a basket of bonds of variable credit quality and risk as a single, all-or-none transaction, whereby the trade instruction specifies that the entire order must be filled. It is a fixed-income trading strategy designed to generate liquidity efficiently, especially in relatively illiquid and high-yield bonds. It is a faster and cheaper way to shift bundles of securities than over-the-counter trading, bond by bond.

The global financial meltdown resulted in regulatory changes that made it more costly for banks to hold on to riskier assets. Financial institutions became reluctant to have inventory on their books that would be difficult to hedge.

The pandemic and working from home strengthened demand for more efficient trade executions. Moreover, financial market regulations such as MiFID II have helped drive more post-trade transparency, audit trails and proof of best execution.

The gradual electronification of the credit market, a corner of finance where personal relationships, phone calls and manual processes traditionally got most deals done, has helped foster more innovation.

The ETF link

Momentum in portfolio trading is closely tied to the boom in Exchange Traded Funds (ETFs), which started out as passive equity investments in the 2000s before diversifying into actively managed ones and credit ETFs.

ETFs typically track a particular index, sector, asset or commodity and can be bought and sold on the open market throughout the day. There are thousands of them; they are relatively cheap to manage and flexible. In short, they are a boon for asset managers in need of efficient asset allocation and portfolio rebalancing.

In bond portfolio trading, dealers unpack an ETF to create a more customized basket of securities and mitigate risk by hedging the bundle against the ETF. Investors choose which bonds they want to include.

The COVID-19 crisis in 2020 saw wild swings in market volatility and an extreme squeeze on liquidity in fixed income. Credit ETF volumes shot up as investors sought to mitigate their exposure to underlying bonds. Most ETF trading occurs in the secondary market, and when markets are tight, they can provide a fast and accessible source of liquidity.

With an estimated USD 1.8 trillion in assets under management, bond ETFs still only make up approximately 1.6% of the global bond market. Most of that is in the US, where credit ETFs represent 3% of the total bond market. In Europe it’s close to 2% and much less than 1% in Asia-Pacific.

ETF adoption and benefits

ETFs and portfolio trading benefit smaller players, who previously may have found it more difficult to get a slice of primary bond allocations. Exposure for them is now easier.

Unlike ETFs, a basket of bonds in portfolio trading is offered via platforms to a reduced group of participants. It’s not shown to the wider market, thereby minimizing the chances of a negative impact on pricing or disrupting the market.

Overall, the speed of trading buckets of bonds in one transaction and certainty of execution have made the strategy a popular alternative in the fixed-income landscape. Firms can trade hundreds of bonds in minutes when previously it might have taken days.

This more efficient execution, enabled by technology and algorithms, means trading desks can shift resources to other areas, such as analysis, strategy, risk management, and client meetings. Automated workflows from trade order to execution cut risk and costs.

Moreover, as ETFs trade throughout the day, pricing is more abundant and transparent. ETFs are a powerful price discovery tool for the underlying bonds, which, as standalone securities, might not trade daily at all.

Sell-side, buy-side

Following the financial crisis, the ensuing liquidity squeeze and tighter regulations on banks, the proliferation of non-bank liquidity providers has given fresh impetus to portfolio trading.

The traditional sell-side has more competition, but portfolio trading is a convenient tool for them to optimize portfolios while diversifying risk with a greater breadth of bonds. Market-makers can save costs and time in their workflow.

The buy-side has taken great advantage of the strategy. Using powerful technological tools to analyze mass volumes of data efficiently, the appetite of institutional investors to build portfolio trades quickly has expanded exponentially. Investors can put money to work fast.

Data plays a fundamental role in the protocol, as it does across all segments of the capital markets. More data, current and historical, helps traders and clients make better-informed decisions, whether it is transaction cost analysis, customizing buckets of bonds, counterparty profiling or deal execution.

Inherent complexity

The complexity of portfolio trades can be greater than that of ETFs due to their inherent flexibility. In the same single transaction, a bank may need to both sell and buy bonds, which requires more bespoke handling.

Asset managers and trading desks can switch protocols in the search for the best prices. Depending on the composition of the basket of bonds they are selling, they either trade electronically or send out a more traditional Request for Quest (RFQ) to the institutional market.

Voice and bilateral communications continue to play a role in credit markets.

Regional differences

Better data is pivotal for transparency and efficient trade execution, but there are significant regional differences.

In Asia, illiquidity in credit often makes it difficult to obtain pricing transparency. The adoption of portfolio trading, automation and algo trading is considered lower in Europe than in the US, which has a central database of prices known as a Consolidated Tape. The data feeds into algorithms and analysis, leading to better feedback.

There is no Consolidated Tape yet in Europe. That’s not a huge problem for investors and banks with deep pockets who can buy streams of data from various platforms to obtain a broader perspective of prices. It does, however, put smaller participants at a disadvantage.

The lack of continuous firm prices required for low-touch or algorithmic trading means firms have relied more on traditional RFQ. Nevertheless, selecting the right market-maker and trading platform can still make a difference. With two-sided quotes and information history, customers are still able to obtain a material improvement in trade execution.

What’s more, with the European Union recently approving a Consolidated Tape for bond prices by mid-2025, the path for greater adoption of portfolio trading and credit ETFs in the region looks clearer.

A bright future

Previously used sporadically for smaller trades and end-of-day portfolio rebalancing, the protocol has seen trade sizes steadily increase in just a few years and become a tool for full portfolio transitions.

Its adoption as a fixed-income strategy is on the rise and higher volumes will lead to more automation and speed of execution. According to a June 2023 global poll by Barclays, close to 12% of clients were trading a quarter or more of their flow through portfolio trading, a rise of 8% year-on-year.

Systems backed by artificial intelligence that can analyze masses of data to detect patterns and unlock hidden liquidity efficiently will also foment demand. And with blockchain and smart contracts seeping into every market, data accountability across the buy-side and sell-side will also improve.

Those who leverage technology will gain a competitive advantage by being able to adapt investment strategies quickly as market opportunities evolve. Whatever the credit trading strategy chosen by operators in the credit market, the implementation of more efficient internal systems throughout the lifecycle of a trade is inevitable.