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NARRATOR: Welcome to Viewpoint, a TD Securities podcast. Listen in as we draw perspectives from a variety of thought leaders on key themes influencing markets, industries, and the global economy today. We hope you enjoy this episode.
PETER: Welcome to episode 22 of Viewpoint, a TD Securities podcast where we discuss emerging themes in capital markets. Today, we're going to dig in on credit markets in the United States, a $10 trillion market undergoing incredible structural change.
Joining me in this episode are three TD Securities colleagues, Marty Mannion, Matt Schrager, and Jason Wynn. Gentlemen, thanks for joining us today.
MATT SCHRAGER: Thanks, Peter.
PETER: OK. Marty, I'm going to start with you, actually. At the start of the summer, you and Matt celebrated your second anniversary at TD Securities. You guys had joined TD in July of 2021 as part of the team from Headlands Technology. That was acquired by TD Securities to help build out an electronic market making presence in US fixed-income asset classes, including municipal bonds and credit.
Up until a few years ago, these asset classes were almost entirely voice businesses. How much has the muni and credit space in the US changed in the two years since you guys joined the firm? And what specifically has changed? We'll start with you, Marty.
MARTY MANNION: Yeah, sure. Thanks. First, Peter, thanks for having us on. Let me just first provide just a bit of historical context. As from our prior discussion, we made a bet when we launched the business back at Headlands in 2013 that the fixed-income markets were going to be disrupted by a dramatic increase in electronic trading.
As we'd seen in other asset classes like equities and options in the late '90s and early 2000s, regulatory scrutiny around best execution is often a primary catalyst driving this sort of disruption since it forces dealers and intermediaries to execute orders more efficiently, which then drives down the cost of execution through tighter bid-ask spreads and lower commissions.
Now, this ends up being a fantastic outcome for investors but does present real challenges for incumbent dealers, since the only way for these dealers to compete in this type of market is by investing heavily in technology and automation.
The same process got underway in fixed income when the SEC published a major report proposing equity-like rules for the fixed-income markets back in 2012.
Now, many of these rules have been implemented by the SEC, by FINRA, by the MSRB-- rules such as best execution, order handling disclosures, and others. But as a result of this, we've seen a steady uptick in electronic trading adoption over the last decade. And that's only continued in the last two years. In 2012, approximately 10% of the IG credit market traded electronically. Today, that number is up to 40%.
We've seen effective spreads, especially for smaller retail orders tighten dramatically. And on the largest IG credit venue, roughly three-fourths of all order responses come from algorithmic trading firms.
I think one of the most exciting changes for our group in the last two years is the interest in electronic trading for many of our customers, driven in part by the rising rate environment. Asset managers are now extremely focused on improving workflows and finding much more efficient ways to trade. And at TDS, we think we're very well positioned to deliver real liquidity when clients need it in an automated fashion.
I'm going to turn it over to Matt, who can get into a few more of the specifics around changes since we've joined TD a couple of years ago.
MATT SCHRAGER: Yeah. Thanks, Marty-- appreciate it. And I think you covered it well. I don't think there are too many brand new trends over the last couple of years. It think it's more of a continuation of the inexorable march, if you will, of technology and automation that we've seen over the past decade or so.
However, I do think that we've seen an acceleration of some of these trends, particularly among the buy side, as Marty mentioned previously. Whereas I think it's fair to say that the sell side has been investing heavily in fixed-income automation for a number of years now, on average, I think aside from some important early movers here, I think it's fair to say that the buy side has been a bit slower to adapt. And I think that's pretty common when markets change that the sell side tends to move a bit in advance of the buy side.
But we're now really starting to see some of these trends proliferate with more clients, both through internal sorts of investment at the firms that can support it and also through partnership with a rapidly growing and actually pretty impressive ecosystem of third-party providers. So for example, products like investor tools have been gaining traction. And these tools allow investment managers to really efficiently manage large, diverse sets of client accounts with very minimal friction, which is great.
I think one other trend that's worth mentioning that's really accelerated in the past couple of years is the importance of ETFs. Everyone knows what ETFs are. ETFs have exploded as an asset class over the last few years across all products. That trend is relatively newer in fixed income. But I think it's really taken off recently, especially the back half of 2022.
They're a convenient wrapper for investors to get generic exposure to fixed income with minimal friction in a format that they're used to seeing. They just trade it like stocks. So that's great. They're not a perfect replacement for individual bonds. But I think they're simple. They're easy. And we do expect that they will continue to grow.
And insofar as that improves access and liquidity in the fixed-income ecosystem overall, we think that's a good thing. So as you might expect, like many liquidity providers, we've invested heavily in ETF-related functionality.
PETER: Yeah. I've said many times, I believe that the launch of fixed-income ETFs, which, by the way, started in Canada in the early 2000s, was in fact a more important development in market structure than even the launch of ETFs in the equity space back in 1990, also in Canada.
And that's because equity investors already had access to marketplaces with bid-ask spreads that were public that institutions and retail traded at the same price. But in fixed income, that wasn't the case. You didn't have that transparency. You didn't have that on exchange pricing. And now you do. And I'm really interested to hear how that space has evolved.
So I should have mentioned, by the way, guys, welcome back to the podcast, as I did have you on as a guest a year ago. And I'll also say Jason Wynn, welcome to TD Securities because you just joined the firm in April of 2023 as head of the US IG Credit Trading Group. And you had a successful 18-year career at a bulge bracket dealer.
That leads me to the question, what motivated you to move from a bulge bracket dealer to a relative upstart in US credit trading?
JASON WYNN: Thank you. First of all, thank you very much, Peter, for having me and joining Matt and Marty here. The biggest motivation for me is ultimately to build a differentiated and impactful credit trading platform with a great team. And that's why I decided to join TD Securities.
I think the future of credit sell side trading really depends on two things-- the two types of trading to become successful. The first and more-- as you alluded to, the more traditional voice-based and originate-to-distribute model is what I'd like to call a depth-based approach. It tends to specialize in the ability to move block-sized risk in individual bonds. And that model of trading has traditionally been the stronghold of the bulge bracket dealers.
Now, as the market has seen more electronification, a more breadth-based approach has become way more important. This is where clients want to move risk and larger numbers of bonds, but in usually smaller sizes per bond, and require more automation from liquidity providers.
The growth of fixed-income ETFs, portfolio trading, which is in just a protocol of an all-or-none list trading protocol, and also just the increased algorithmic trading are all related to this growth in this second approach.
And I joined because I think TD has all the necessary ingredients to build up both of these approaches. On the voice side, we have a global institutional client reach, a AA balance sheet, and a growing debt capital markets business.
And clients are also looking for additional liquidity providers as the corporate bond market has grown exponentially over the last decade or two, while aggregate dealer balance sheets have overall stagnated.
And what makes TD unique and almost, I think, a prerequisite for where I wanted to build the credit business, is having the TD Sec technology partners in Matt and Marty, to build up the complementary automated trading business. I think what they have done so far in the muni market is truly unrivaled. And I'm pretty confident that as we focus on the corporate bond market, we will also build a highly-differentiated credit algo that will be among the best in class for that breadth-based market making component that I think is becoming equally important as the traditional depth-based approach.
PETER: So Jason, as I think about equity markets, I think about equity strategists helping out institutions on when they should buy and sell stocks, individual analysts helping out on research with respect to how companies are performing.
And in the credit world, I know there's credit strategists. How important is credit strategists and credit strategy to the overall ecosystem that you're trying to build within TD Securities?
JASON WYNN: I think it's very important. I think when I think of credit strategists, they generally focus more on the macro trends of credit instead of necessarily focusing on the idiosyncratic moves of individual issuers or talking about what are the overall trends in the market-- the technicals, the fundamental backdrop, the relationships versus other asset classes such as FX, equities, and rates.
And that is something we're excited. We hired a new equity-- sorry-- a new credit strategist. We hired a new credit strategist, Hans Mikkelsen. He's going to be working with us very closely as well.
And I believe the overall trend of where the credit markets have gone is as it has become more electronified, and this breadth-based market making has become more important, the asset class itself overall has become more macro driven. So you see over the correlations of the asset class as a whole has tended to be a bit higher over the last few years.
PETER: Well, I'm excited to learn a little bit more from Hans. Certainly, it's a space that I don't know well enough, and look forward to being educated on.
And so Matt, clearly TD is marrying together two important skill sets needed to adapt to this changing trading dynamic of credit trading. In your mind, what does the end state of the marriage between electronification of credit trading and the voice or upstairs business look like? And where would we be at in that journey?
MATT SCHRAGER: As you know, Peter, and maybe some of the listeners do as well, Marty and I come from more of a low latency, high frequency trading background, back to our time at Headlands Technologies.
So you might think that our answer here would be the computers are going to take over everything and the humans are going to be relegated to a corner of the market, et cetera, et cetera. That's sort of what happened in equities and futures, where nearly all trading is. It's very highly automated, of course. But that is really not what we think is going to happen in fixed income.
We do think that fixed income is going to follow the same sort of broad, historical path as those other markets. And it's going to continue to lean more heavily on technology over time. But I think that the specifics of that path are going to be meaningfully different in ways that are going to prevent fixed income from ever looking quite exactly like equities.
And I think that really comes from just inherent differences in the market structure of fixed income that make it really unique. As one example, there are just far, far more individual securities in fixed income than there are in equities.
So for example, there might be a few thousand liquid tradable equities compared to if you just take one fixed-income asset class, like municipal bonds, for example. There's north of a million individual securities in just that one market alone. So it's quite a different market liquidity landscape.
I think the client base and the mix of volume in fixed income is also quite different. So for example, corporate bonds are a much more institutional market than, say, equities, where the average trade size is well into the hundreds of thousands of dollars worth of par value. And there are tons of trades that are for many millions or even tens of millions of dollars of par value.
And even in equities, really large trades like that are primarily handled by, or at least have a lot of input from human traders, right. And that's, of course, also true in fixed income. And we don't really expect that to change.
The difference in fixed income is that these trades-- these larger trades make up a relatively larger proportion of the overall market. So the relative importance of the traders who handle them will, of course, be higher.
Having said all that, we very much do expect that the nature of human-driven institutional trading is going to evolve-- is already evolving as we speak, just as it has in other markets.
So what we think you'll see a lot more of over time is what we call the hybrid model, where human traders remain a critically important part of the market, at least for these larger institutional size orders. But they're really empowered by very sophisticated quantitative modeling and workflow automation tools and various other forms of technology that allow them to do their job much more efficiently and precisely.
And at the best places, I think that the technology and the modeling will be seamlessly interwoven with trader workflows, such that the, quote, unquote, "algo" aspects of the business become an integral input into the traders' jobs. And then vice versa-- in turn, the traders are helping evolve the algo over time with their experience and their intuition, their feedback, et cetera.
PETER: So Jason, along with the theme of electronification, what would you say are some of the other high-level themes in the credit space currently?
JASON WYNN: Overall, credit has never been a more interesting asset class in recent memory. And at 5.5% yield roughly right now, it's one of the highest points it's been in the last 15 to 20 years. And it is drawing global demand across more and more investors. And more eyes are on it.
At the same time, the credit spreads over the corresponding treasuries have neared the post-pandemic heights, or at least the last two year heights. And thus, I think it's a lot more subject to macro-driven volatility.
So overall, I think there's a lot of risks to monitor. But also at an overall all-in yield level, it is an incredibly interesting asset class.
I also think credit dispersion will be something that will be a key thing to watch. As potentially default rates pick up in high yield, that's something to see about how we've had an era of quantitative easing for such a long time. That's generally created for less credit dispersion where some of those macro factors, as I alluded to earlier, were the primary drivers of overall credit spreads.
But as dispersion picks up and default rates pick up, it's worth watching how that increase will impact the trends that we have seen and also impact what will happen to the automation light strategies that are out there that are more just purely passively looking at third-party prices and have not put as much thought behind how you automate during stress times and higher volatility times.
PETER: So we have the highest base rates we've seen in-- what-- 40 years. And as you say, we have very tight credit spreads right now. I'm curious how issuers are reacting to the current environment. Are they willing to issue with tight spreads, or are they concerned about those high based rates that's holding them back from wanting to issue in this market?
JASON WYNN: That's a great question, Peter. I think there are actually many factors that influence issuance trends. 2020 and '21, for example, were two record issuance years for IG supply at $1.8 and $1.5 trillion. And it's no coincidence those two years saw the lowest base rates ever.
In the two years since then, we're still tracking for about $1.25 trillion each year, which is in line with pre-pandemic averages despite the high base rate. Banks will always need to issue for regulatory capital. And changes on that front may increase needs for regional banks.
M&A was also robust in 2021 and '22, especially in the TMT and healthcare sectors. And on a trailing basis, that has buoyed issuance needs for corporates. We think overall, issuance may trend down slightly next year.
PETER: Well, I'll be watching closely how that market evolves. And just as we finish up here, Marty, I want to ask you a question about one of the behemoths in the electronic space that I'm familiar with in the equity world. That's Citadel. A couple of months ago, Citadel declared that it was going to be taking over, essentially, or announced its intentions to take a big step into the liquidity provision in the credit space in the US.
I'm curious what it means when a Citadel says they're going to take over this market. Do you expect that they will actually follow through on those intentions? Obviously, you're going to compete hard. But I'm also curious if you think this will open the floodgates for some of those other electronic market makers that I'm familiar with in the equity space also wanting to transition into credit market making.
MARTY MANNION: Yeah, Peter. That's a great question. And I think Citadel getting involved in credit did not really come as a surprise to us, as you pointed out. They're a formidable liquidity provider, really in every market that trades electronically. And I think their announcement is further validation of the trends that we've talked about today.
Believe it or not, a number of alternative liquidity providers are already active as market makers in the fixed-income space. So I would say that the floodgates have been open for some time. As you well know, anytime markets automate, you do see the entry of new alternative liquidity providers often coupled with significant consolidation amongst the traditional dealers.
As you mentioned, a great example is from the equity markets. Early 2000s, every retail broker operated its own market maker. But then a combination of rule changes and advances in electronic trading made it prohibitively expensive to operate these types of liquidity provision businesses in house. It was much easier to simply outsource the execution process to alternative liquidity providers like Citadel, who invested heavily in technology, in quantitative modeling, and were not saddled with the legacy infrastructure of traditional players.
I think we're seeing a similar consolidation story play out on fixed income. To cite just one example from the muni space, the number of MSRB dealers has declined over 40% in the last 15 years. And we only expect this trend to continue.
Now, all that said, I do think there are differences between credit and other asset classes that both Matt and Jason touched on earlier that provide incumbent banks with certain key advantages over some of these alternative LPs.
For example, the sheer number of tradable instruments in credit means that you have to carry a significant amount of inventory. And really, the only way to do that is with a sizable amount of capital.
In addition, bonds and fixed-income products trade via an over-the-counter market, which makes deep relationships with hundreds, if not thousands of clients critically important. And it can be difficult for all but the largest alternative LPs to match the capital and distribution advantages enjoyed by the large integrated banks.
But in closing, I would say at TDS, we think we're uniquely positioned to marry these inherent bank advantages with world-class technology and trading, especially with Jason recently joining the team. And we think this puts us in a really unique position.
PETER: Well, it is exciting. We're watching the evolution of our credit trading business in the US evolve alongside the evolution of the equity business, which obviously took a big bump when TD bought Cowen earlier this year. And so we'll be watching those two businesses evolve south of the border.
As you guys know, I'm a bit of a market structure nerd. And there's a lot to dig into that we just scratched the surface on here in this podcast. And with your blessing, I'd like to invite you folks to someday come on to a sister podcast that I'm responsible for called Bid Out, which focuses on market structure trends. And that is also available on Apple and Spotify and the like.
And I would love to have you guys on where we can dig in on some of these nerd topics for some of the people that really are watching the evolution of that space closely and clearly. We've got some expertise that I'd like to be able to leverage.
So hopefully, you guys will join us on Bid Out down the road. And for now, I want to thank you all for coming on today to Viewpoint. And Jason, once again, welcome to TD. And we'll look forward to chatting again soon.
MARTY MANNION: Thanks, Peter.
MATT SCHRAGER: Thanks, Peter.
JASON WYNN: Thank you Peter.
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NARRATOR: Thank you for listening to Viewpoint, a TD Securities podcast. If you enjoyed this episode, subscribe to this series on Apple Podcasts or on your favorite podcast platform. For more thought leadership content, visit tdsecurities.com. And follow us on LinkedIn for all the latest TD Securities updates. For relevant disclaimers to this podcast, please refer to the Viewpoint episode page on our website.
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