Three Emerging Trends in Bond Pricing

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It may seem like an esoteric and arcane topic to some, but the business of bond pricing is mission critical to the survival and ultimate success of the industry. Sound bond pricing is fundamental to the calculation of NAV, investor purchase and redemption prices, manager and trader performance reports and subsequent income calculations, market risks and exposures, regulatory reporting and audits and many other key operational functions.

In asset classes such as equities and derivatives, current trading provides the means to provide an updated valuation for investment holdings. This is not the case for much of the fixed income markets, where very little trading takes place outside of a small proportion of the most liquid bonds. Some studies suggest that as little as 2-3% of the outstanding number of bonds in issue trade in any kind of regular or meaningful way. Trading volume also degrades over time as new issues find their way into long term investment portfolios, never to see the light until maturity.

The only realistic way to update prices on all those bonds that do not trade, is to either obtain broker quotes from dealers or to use some kind of model or algorithm to extrapolate trading activity to the illiquid market via benchmark yield curves and credit spreads (usually referred to as Evaluated Prices). In both cases, access to observable prices from liquid trading activity is vital to understand changing underlying market levels and conditions.

While the issues surrounding bond pricing and valuation are many and varied, three emerging trends in the landscape merit particular attention:

1. Electronification

Until relatively recently, bond trading in both the primary and secondary markets relied largely on manual processes. The electronification of the bond markets have lagged significantly behind those of equities and derivatives. Much of this is structural, with different trading systems and a lack of standardization of instruments, but there has also been some reluctance amongst trading firms to reveal their hands.

Despite these impediments, new protocols and platforms look set to transform this market. Innovative approaches such as Distributed Ledger Technology (DLT) and blockchain are being trialled in the new issue market to improve both workflows and the dissemination and storage of data. In the secondary markets, electronic trading platforms are better established and more and more trading volume is being transacted in this way.

The implications of this trend for bond pricing is that more transactions will be recorded and distributed in electronic form. This will make it much easier for investment firms to assess the range of current trading levels for their inventory and for dealers and pricing vendors to access trade activity data for quote and Evaluated Pricing purposes.

2. Liquidity Provision

Traditionally, buy-side firms would receive quotes on bonds they were interested in from their dealers. The dealers would provide two-way quotes and also hold inventory on selected bonds, thereby providing liquidity for the market. This all began to change following the financial crisis, when new capital constraints and profitability challenges led to many dealers reducing inventories and market-making capabilities.

These developments, accompanied by the growing size and market power of some fixed income investment funds, have led buy-side firms to increasingly become price-makers and liquidity providers in their own right. This is especially true in times of stress and liquidity constraints.

The ramifications of this situation for bond pricing is that quotations on bonds may no longer just be sourced from sell-side dealers. To obtain a true picture of the market for a particular issue, note will need to taken of buy-side levels through trading platforms and data vendors servicing this market segment.

3. Regulatory Reporting

With the bond markets trading Over The Counter (OTC) rather than on exchanges, it was historically challenging to discover what trades took place and at what price and volume. This started to change in 2001 when the SEC introduced the Trade Reporting and Compliance Engine (TRACE) requiring dealers to report trade information for US corporate bonds. Administered by FINRA, the scope of TRACE has been extended to other bond types over the years, including Treasuries and some asset-backed securities. In 2005 municipal bonds followed suit with the introduction of the MSRB’s Real-time Transaction Reporting System (RTRS).

Outside of the United States, progress on ‘official’ trade reporting and transparency has been slower and more patchy reflecting the more disparate market landscape. However, the European Union has introduced some reporting requirements under MiFID II and is considering the production of a Consolidated Tape (CT) for European bonds. The International Capital Markets Association (ICMA) also provides guidelines and recommendations on secondary market price dissemination.

The significance of these developments is that increasing amounts of ‘real’ trading in the fixed income markets will be reported and publicly disseminated. The improved availability of this data will enhance the quality of quote and Evaluated Pricing provision.

To address these and other issues, in 2022 the BDA created the Bond Pricing Institute. The mission of the BPI is to promote professionalism and best practices in fixed-income securities pricing through advocacy, education, and communication. Improved pricing and valuation of fixed income securities to benefit investors is of primary focus.

More information is available on our website at https://bpi.bdamerica.org/ and interested parties can contact Ian Blance on iblance@bdamerica.org for more details and membership options.