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Jeff: Welcome to the Flip Side, I’m Jeff Meli, Head of Research at Barclays. Corporate bond and loan markets have traditionally been pretty rigid. Compared to equity markets, they have been characterized by low liquidity, low trading volumes and higher transaction costs. But between the explosion of credit ETFs and the growth of private credit markets, all that is changing.

Today, my colleague Zornitsa Todorova and I are going to talk about whether active investors will benefit from a trend we call the ‘equitification’ of credit. Zornitsa, thanks for joining me. 

Zornitsa: Excited to be here Jeff. 

Jeff: I think the fact credit markets are becoming more like equity markets is going to be good for active investors. They’re going to be able to deploy a wider array of strategies to generate returns and outperform their benchmarks.  

Zornitsa: I disagree. I really think that this new trend is going to make life tougher for active managers. I believe we are going to see market efficiency rise, volatility drop, and then to me the ultimate winner will be, actually, passive investing.  

Jeff: Alright, let’s get into it. One aspect of the ‘equitification’ story is that public credit markets are becoming significantly more liquid.

Zornitsa: Yes, Historically, bond markets have been much less liquid compared to equities. What I mean by that is that it costs much more to buy and sell bonds than it does stocks  – and as a result, managing a bond portfolio is substantially more challenging.  

Jeff: The constraint on corporate bond liquidity is linked to the large number of securities. Any given company has only one stock outstanding, but it can have many, many bonds outstanding. Take Apple as an example: ticker AAPL is the stock, one of the most valuable companies in the world. That same company, it has literally dozens, I think the actual count was 62 bonds outstanding.  

Zornitsa: That’s right, and because there is only one Apple stock, it’s very easy to trade: at any point, there are lots of buyers and sellers, and computers match their orders electronically, and so trading is very cheap. Even retail investors can get in on the act. They can open a brokerage account and trade stocks with little to no commission fees.  

Jeff: Now, that doesn’t work with bonds and loans because it is a lot harder to match buyers and sellers. If you want to buy an Apple bond and I want to sell one, we have to get lucky that we both picked the same bond, we’d have to get pretty lucky to match our orders. That’s why most bond trading isn’t automated; it’s done by banks and other market makers in what’s known as the over the counter, or OTC market. The market maker takes positions into inventory and then figures out over time who will take the other side of the trade; this makes the transactions much more expensive, and leads to lower trading volumes. That’s why we say bonds are less liquid.  

Zornitsa: I agree, but this is where we are observing this ‘equitification’ in credit markets, and bond ETFs have really been at the core of that shift.  

Jeff: Right, an ETF, or exchange traded fund, is similar to a mutual fund: it owns a diversified portfolio of assets, usually linked to a benchmark or specific strategy. The big difference is that ETF shares trade on exchanges, just like stocks, whereas mutual funds do not.  

Zornitsa: The rise of that whole technological ecosystem that creates and trades ETFs started a revolution in credit trading. Bond ETFs are incredibly liquid – exactly because they trade actively on exchanges, just like stocks. The first innovation was that institutional bond investors who needed to manage daily liquidity - like mutual funds, who get inflows and outflows - started to buy and sell ETFs instead of bonds to manage their liquidity needs. The ETFs provide very similar exposure to the bonds they track, they are designed this way, but the advantage is that investors who use ETFs don’t have to pay the high transaction costs of bonds. You could see why this is particularly useful for mutual funds whose need to trade every day was a drag on performance in the past.  

Jeff: More recently, investors started trading bespoke baskets of bonds. Market makers price and hedge these “portfolio trades” using ETFs; again, possible because the ETFs are so liquid, they can be easily bought and sold, and give real time information about the price of portfolios of bonds. These trends make it much easier to trade credit: the costs of portfolio trades are 40% or more below the cost of traditional trades. This boosts credit liquidity and it’s now a lot closer to stocks.   

Zornitsa: What I think is most interesting about this new protocol is that it turns the historical weakness of credit that you just talked about into a strength: investors typically own vast number of bonds, so while it may be hard to trade any individual bond, it’s relatively easy to construct portfolios that can be then priced and hedged using ETFs. So, one way to think about portfolio trading is like credit investing but with equity principles.  

Jeff: Agreed, and that same flexibility is also why I think active managers benefit. First, think of the typical fundamentally driven investment style that is used in credit.  

Zornitsa: Yes, investors would analyze individual companies, and pick those that they think are going to grow and thus be better able to pay off their debts.  

Jeff: As the costs of trading go down, it becomes easier to take advantage of these opportunities because you’re not paying away so much of the upside in transaction costs.  

Zornitsa: I’m not sure it’s that simple in the end. An important source of these opportunities is forced selling. When one investor needs to sell – say they need to raise cash because they have a big outflow. In the past, they would need to pick some bonds to sell. That could cause the prices of those bonds to drop, which then creates an opportunity for other investors to step in.  

Jeff: Sure, and the price impact can be large, because of the matching problem we spoke about.  

Zornitsa: Right, but now that same investor doesn’t need to pick a few bonds to sell. They have other options – they can sell ETFs or they could do a portfolio trade - and so there’s no chance for other investors to pick up cheap assets. That makes it harder to generate returns, and to my point earlier, makes the job of active managers more difficult.  

Jeff: That’s an interesting point. But at the same time these new liquidity management tools have really expanded the investing styles and strategies available to credit investors. Take for example factor and systematic investing. These types of automated strategies were limited to equities for a long time, but we now see them pick up momentum in credit.  

Zornitsa: OK, that’s true. These new strategies use quantitative models of bonds, looking for signals of which bonds will outperform. The source of signals varies widely. Some, like value or growth strategies, are based on the characteristics of companies. Others might look for hints in more unconventional data sources. For example, they could use machine learning or artificial intelligence tools to dissect earnings calls, press conferences or even satellite images. As you say, some of these strategies are old hat in equities.  

Jeff: I also imagine that the combination of more data and new technologies have increased the demand for data-related jobs? 

Zornitsa: That’s right. ‘Data science’ jobs were not even a thing 10 years ago, whereas today about 10% of the new job postings are looking for ‘quants’ or ‘data engineers’ or ‘data scientists’. 

Jeff: These new quantitative strategies require being able to trade lots of securities, like hundreds or even thousands, in small sizes, generating small returns from each trade. If you ask me that sounds like a perfect fit for portfolio trading: investors can execute this strategy very quickly and efficiently, but before portfolio trades this was too expensive.  

Zornitsa: I agree, and we have in fact seen the first of these strategies being implemented in the corporate bond market. But how does that address the lack of volatility? 

Jeff: First of all, it’s a new way to generate returns, which I think will feature in an increasing number of strategies, even those that aren’t officially quant. Second with more styles, there will be more chances that they will have offsetting views. If a bond looks good to quant funds, they might push up the price, and the fundamental investors might think it’s too high, and sell, or vice-versa. Not all investors look at the world through the same lens, and that means more opportunities for everyone. 

Zornitsa: Well I have a different perspective here, and that's where the other aspect of equitification comes in: the rapid development of the private credit market. 

Jeff: Private credit is all the rage: the market has grown significantly over the past several years, and although estimates of its size vary, it is fair to say that between the US and Europe it is over a trillion dollars at this point. Of course, equities have long featured both a large and liquid public market and a robust private market.

Zornitsa: Both companies and investors use the public and private markets for different purposes. It would depend on the maturity of the company – for example, whether we are talking about a start-up or a more mature, large company. For investors on the other hand, their preference depends on their style and holding period. But the point is that access to the two types of markets provides significant flexibility for everybody.  

Jeff: And now we see this happening in credit. Ten years ago, the private credit market used to be limited to small companies, but it’s now a viable alternative to the public market for all but the largest issuers, which is similar to the situation in equities.  

Zornitsa: I think we agree that this development is unambiguously good for issuers. Today, companies have more options when they need to raise funds - for example, some issuers might prefer the limited disclosures of the private market, others might use the depth and liquidity of public markets. Or they can even do a combination of the two, switching back and forth between the public and private market depending on pricing and their specific needs or the situation that they are in.  But the story for investors is more complicated -- and that is because of an important link between the two aspects of equitification:  The growth in private credit is linked to the increased liquidity of the public market. And that’s because that improved liquidity actually has a direct effect on the liquidity risk premium.  

Jeff: Generally an asset that is illiquid will earn higher returns: investors have to be compensated for taking the risk that the asset can’t be easily or cheaply, sold or managed. That has historically been an important source of returns in credit. Bonds were really hard to trade, and if you were forced to trade your performance could suffer. So you insisted on higher yields.  

Zornitsa: Yes, and our recent research shows that the liquidity risk premium has declined by up to 50% - that’s quite a lot. That’s exactly because it is so much easier to trade illiquid assets today: it makes total sense, if it’s easier to trade, why should you get the same premium? But of course, there are lots of investors out there who don’t trade that much.  

Jeff: Sure, pension funds, insurance companies, endowments. they don’t often need to trade because they don’t have inflows and outflows, like a mutual fund or hedge fund.  

Zornitsa: exactly, and that allowed them to free ride on the liquidity premium: it was like free money for them. But now that has changed: the premium is lower and they don’t find public credit as attractive anymore. So instead, they turn to private credit, where they can possibly still capture that premium.  

Jeff: That’s very similar to what we see in equities: If you need to trade, or use a high turnover strategy like quant investing, you go to the public market, and if you have very long horizon, you look for opportunities in the private market.   

Zornitsa: But doesn’t this imply that the returns in the public market are lower today? In other words, active managers can trade more easily, that I agree with, but then their returns also fell in step with that improvement. They aren’t really better off, are they?!

Jeff: Ok look…the goal of an active manager isn’t necessarily total returns, it’s really returns, relative to their benchmark. Beating the benchmark gets easier when trading is easier. Sure, the total returns may be lower from the standpoint of a pension fund, but if a mutual fund beats the index it will attract assets.  

Zornitsa: Well, it’s interesting that the trend in equities has actually been the other way: the assets in passive strategies, which charge much lower fees for simply matching a benchmark, have grown, and active managers have a lower share. This despite all the liquidity. I think part of the story here is that markets became more efficient as liquidity increased. 

Jeff: Efficient markets mean something different to a lay person, often than it does to a finance person. To a finance person, it means, not so much functions smoothly, but rather than prices are close to fair value, based on all the information available to investors.  

Zornitsa: Look at all that quant and factor investing, and also how much easier fundamental trading has become. The new tools mean that investors are better able to take advantage of any deviation from fair value. With a greater ability to exploit discrepancies, it could be the case that there are just fewer opportunities. Sometimes you have to be careful what you wish for! But on the flip side, an illiquid asset class such as credit can offer fertile hunting grounds, so to speak. 

Jeff: Sure, but harder and more expensive to take advantage of the opportunities, it’s harder to translate into returns. We’ll have to see how these trends play out; it’s still early days in the ‘equitification of credit’ and it’s going to gather steam over the coming years.

Zornitsa: Yes, our team are watching this trend closely and will keep clients updated 

Jeff: Thanks Zornitsa. You can find a link to our Research on this topic in the show notes below, and clients of Barclays can get a more in in-depth view of this and other forces shaping fixed income markets by accessing the 2024 Equity Gilt Study on Barclays Live.