Improving Bond Market Liquidity - The Silver Bullet

by: Kurt Dew

The developers of bond market trading, mostly broker-dealers, have failed to create markets with liquidity comparable to stock markets.

This is because bond market governance has failed to represent bond buyers adequately.

Issuers, by focusing on each bond’s issue price separately, fail to capture the negative effect of covenants on the market wide value of debt.

An exchange created and managed by bond traders would make bond investing more attractive.

To liquefy the bond market, the financial risk management profession thinks to introduce the innovations to bond trading that led to the stock market liquidity/volume explosion of the early 21st Century. Various financial firms have introduced four principal innovations:

  • Index funds
  • Futures contracts
  • ETFs
  • Electronic trading platforms

With only middling results. Applying the changes in stock market trading to the bond market without any change to the bonds themselves has met with indifferent success.

Bonds are different

Because bonds are different. The bond market skipped an important step in its evolution. Unlike the stock market, the bond market has never benefited from a market governor - an influential private sector governing body - as the New York Stock Exchange once was - that balances the joint interests of bond issuers and bond traders - and so serves the needs of buyers as well as issuers.

There is insufficient pressure on bond issuers to protect the value of bonds after issue date. Moreover, there is insufficient pressure on bond issuers to design bonds that are attractive to buyers. Although issuers have ample incentive to bind themselves with covenants within each new issue before the market prices it, afterward the corporate issuer will certainly exercise any term of the bond commitment that works to her favor of at the bondholder's expense.

Because of unilateral bond issuer decision-making, nobody ever asks a key question. Are the terms of this bond, if applied to bonds generally, going to make it easier to price bonds and use them in risk management activities? The market never gets to consider the bond's impact on trading generally. Thus key issues important to the marketplace, like standardization of the bond's covenants and ease of identifying more and less attractive bonds, become overly complicated.

The risk managers that use bonds ought to seek a voice in determining characteristics of newly issued bonds.

How to fix the bond market?

Liquidity is really a byproduct. An instrument trades with liquidity whenever large groups of traders find trading the instrument serves their purposes regularly. Liquidity is an implication of useful.

The users of bonds are the appropriate source of the silver bullet, a liquid, predictable, fixed income instrument. Which tells us how to make the bullet. Bond buyers ought to organize to govern the design, origination, and trading of a buyer-friendly instrument and marketplace. Transformation of bonds that focus on the immediate needs of myopic corporate issuers into fixed income instruments that better meet the needs of bond buyers will change the game.

Success of bond buyer-designed innovations would have beneficial follow-on effects. Popular new kinds of fixed income instruments would create incentives for issuers to adjust the terms of newly issued bonds, once confronted by a landslide of demand for bonds with terms more attractive to bond buyers. The effect would be an overall increase in bond valuations and growth of the utility of debt in financing generally.

Market innovators focus first on stocks for good reason.

Why was the bond market left behind when the stock market was revolutionized? Why did the innovator of index funds, Vanguard's John Bogle; of stock futures trading, CME Group; of ETFs, Amex' Nathan Most and Steven Bloom; and of electronic trading, Jeff Citron and Joshua Levine; not apply their methods to bond trading with the same enthusiasm? Why did they make disrupting the bond market secondary to revolutionizing the stock market?

The answer is that bonds (other than US Treasuries) do not lend themselves to high volume trading. Before the big four innovations that revolutionized stock market trading will have the desired revolutionary effect on bond trading, the first innovation - the index fund - will be replaced with something more revolutionary.

What makes a bond less useful than a stock from a risk manager's perspective?

The primary problem using bonds other than Treasuries as a risk management tool lies at the beginning of the chain of market innovations from index fund creation to electronic platform trading. Since shareholders have the right to make decisions with negative direct effects on the value of outstanding bonds, bondholders would serve their interests by creating disincentives to introducing bond contract terms, such as call provisions, that enable corporations to undermine the value of a bond to risk managers after issue.

These bondholder-damaging decisions vary from reasonable ones such as calling debt with above-market coupons, to less reasonable decisions such as manipulating the value of debt through positions taken directly (or indirectly through third parties) in the CDS (Credit Default Swap) market. Nonetheless, every change in the pattern of bond market cash flow that benefits stockholders works to the detriment of bondholders.

Although a covenant attached to a single bond has little effect on a bond index fund, collectively covenants are a cost to bond funds that has no counterpart in stock index funds. If an exchange-originated bond were to eliminate the effects of bond covenants, the effect on the attractiveness of such a bond, manufactured from multiple individual issues and exchange-traded, would be substantial.

How to manufacture a more useful fixed income instrument

Bond issuance suffers from the prisoner's dilemma. Terms that serve the interests of a single issuer, such as call provisions, work against the value of corporate bonds generally. Issuers would curtail their use of such negative covenants if issuers wrote their bond contracts in the presence of a bond trader-created market that lists only bonds with trader-friendly covenants.

Bondholders need a representative with teeth. They would benefit from establishing a market interlocutor - a middle-man/negotiator that encourages issuers as a group to modify the existing bond market instruments, transforming instruments with unpredictable behavior into predictable instruments that meet risk manager's needs.

The existing corporate bonds will never fill the bill. It is the essence of corporate-issued debt to serve the needs of the issuing corporation first - to benefit stockholders at bondholders' expense.

While bonds promise predictable fixed payments over time, that's a promise bonds don't keep. Bonds' risk management advantage is predictable cash flow, but in fact, corporate-issued bonds are too often unpredictable. The bond is a security that claims the impossible - to serve two masters at odds with each other - to serve the stockholder and the bondholder simultaneously. A fixed income instrument designed by bondholders with properties determined by bondholders would shift the imbalance created by issuer domination of the market. The bond market needs a middle man.

Key components of a new bond market interlocutor

Here's a list:

  • Owned by and managed for fixed income risk managers
  • Lists bond buyer-designed fixed income instruments that outperform corporate debt in service of risk managers' needs
  • Minimizes broker-dealer and exchange fees
  • Creates incentives for issuers to write bond commitments with bond buyer-friendly terms

Owned and managed by fixed income risk managers. How can the bond market be modified to meet these needs? The historical example of an entity that transformed a market built to raise money for corporate purposes into a market built for risk management is the financial futures market.

That key characteristic of futures markets - the condition from which all the other useful eccentricities of futures stem - is a simple one. It is a market designed for traders to serve traders' purposes. Futures traders and brokers made changes to the methods of stock markets, when they designed stock index futures, to suit their needs, not the needs of investment bankers or securities issuers.

The other ways futures markets differ from securities markets all follow. It's not a market for corporations. It is not a market for investment bankers. Thus, the practices of the market favor traders, not bankers, brokers, and corporate issuers.

Nonetheless, there is an interesting side effect of pleasing market users alone. Despite futures markets' focus on the needs of traders, investment bankers were, from the outset of financial futures listing, anxious to get included in futures market management. Investment bankers follow the customer. The customer, in turn, will follow anything that improves the performance of their bonds.

If bondholders want a liquid efficient fixed income market that serves the purposes of fixed income risk managers - pension funds, insurance companies, and other like risk managers - they ought to establish and govern this fixed income marketplace themselves.

Lists bond buyer-designed fixed income instruments that outperform existing corporate debt in service of risk managers' needs. A bond trader's exchange would serve bond traders' needs. Futures don't. Futures fail to meet the needs of bond traders, the way futures work now, because they are not fixed income instruments.

Daily mark-to-market in cash, the salient property of financial futures, is an efficient way to open a risky marketplace to retail participants, but this characteristic is anathema to a pension fund or insurance company that defers recognition of changes in value of the liabilities it buys bonds to hedge. Bond traders need a spot instrument with known reliable future payments only. A bond traders' exchange will only succeed by listing this kind of instrument.

On the other hand, the all-important sine qua non of any exchange-traded instrument is that the instrument be valued by a liquid marketplace at the close of trading daily. For this second valuation purpose, the daily mark to market in cash trading of futures markets is ideal.

A successful bond traders' exchange will find a way to do both.

Minimizes broker-dealer and exchange fees

There is much efficiency built into futures markets because the traders that built them had an eye for unnecessary costs and unnecessary fees paid to the bankers and securities dealers who built the stock exchanges to serve bankers' purposes.

How did futures traders revise stock market trading?

  • A central clearing house run by traders themselves,
  • A margining system more efficient for users than securities lending and borrowing,
  • Use of traders' payments instead of broker-dealer purchases and sales at the close to assure fund valuations are identical in both futures markets and related cash markets.

Interestingly, it is possible to produce a market open to retail traders that prefer to be marked to market in cash daily, while issuing a fixed income instrument that requires no payments at all from buyer once purchased.

Creates incentives for issuers to write bond commitments with bond buyer-friendly terms. In addition to the goal of being useful to bond traders, a liquid instrument ought to encourage issuers to standardize bonds in the market generally. Specifically, a maximum share of the total value of debt outstanding ought to be in a minimum number of listed instruments. More standardization and less quirkiness will help liquefy the bond market.

An exchange that originates and lists its own fixed income instrument has two design tools to use in standardizing and homogenizing the bond market. It can make the exchange-issued instrument simple so that its purpose is clear. Moreover, the exchange can minimize the number of instruments that it lists for trading, thus concentrating user interest in a single high-volume market. To cover a maximum share of debt outstanding, the exchange could identify the most predictable stream of payments flowing from a "package" of bond buyer-friendly bonds, adjusted to meet promised payments on a daily basis by short traders' payments from and to the exchange-created clearinghouse.


The primary obstacle to revolutionizing bond markets is risk manager organization. The old saw that bonds are sold, not bought, still rings true today. Bond buyers with liabilities requiring a fixed stream of income are an enormous part of the financial markets. However, these traders allow the legion of corporate issuers to dictate the characteristics of the instruments they trade at enormous cost to themselves. There is no other reason why the exchange trading of bonds does not exceed the exchange trading of stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.