Despite the rapid expansion of the corporate bond market since the global financial crisis, growing from $4.7 trillion in 2007 to over $10.5 trillion by the end of 2020, investors’ ability to access liquidity has stagnated. Increased regulation, consolidation in liquidity providers and limited appetite for risk taking has led to a consistent decline in turnover and concentration of trading activity in the most liquid part of the market. However, the recent growth of the $1 trillion+ fixed income ETF market, emergence of nontraditional market makers and increased utilization of electronic trading platforms to offload risk has given rise to portfolio trading for corporate bonds.
At its core, portfolio trading is the packaging of multiple bonds into a basket of risk that market makers, aided by technology, price at the portfolio level, allowing investors to trade potentially thousands of line items all at once. Market makers are able to utilize the way in which fixed income ETFs are created and redeemed such that they can exchange or source a portfolio of bonds from the shares of the underlying ETF. These trades do not necessarily need to be linked to an ETF; in fact, portfolio trades can be used to transact illiquid securities as the risk of a few illiquid line items can then be mitigated across the more liquid parts of the basket.
Portfolio trading provides several distinct advantages for investors compared to traditional forms of trading. First, portfolio trading is a highly efficient way to move large volumes of risk. Dealers have the capability to price a $1 billion portfolio in under an hour, whereas trading the portfolio ISIN by ISIN could potentially take days. Portfolio trading can also potentially lead to better execution levels; executing a large number of trades over a prolonged period has the potential to move the market, while trading the portfolio all at once allows dealers to price the risk more appropriately and minimize information leakage.
While portfolio trading does have its limitations as the level of execution can depend on the diversification of the portfolio, its growth has major implications for the market moving forward. The ability to quickly and efficiently move significant risk has given investors more flexibility to tactically deploy capital, utilize more quantitative investing strategies, including factor investing, and more quickly implement goal-oriented portfolio solutions.