Given the attractiveness of convertible bonds to companies with high borrowing costs and volatile stock prices, investors should expect a surge in convertibles issuance in the post COVID-19 world. When these new issues come to market, many will be traded on electronic platforms that are growing rapidly and dramatically tightening bid-ask spreads for investors.
“Relative to traditional telephone trades, investors can cut trading costs significantly by using the RFQ protocol on e-trading platforms,” says Ken Monahan, Senior Analyst for Greenwich Associates Market Structure and Technology and author of Crossed, Locked and Loaded: Trading Convertible Bonds.
Growth in Issuance and E-Trading Volume
After the Global Financial Crisis, convertibles issuance dropped off as low levels of volatility and relatively low interest rates made the issuance of straight bonds more attractive. Interest rate normalization and the return of volatility to equity markets in 2018 have since spurred increased issuance in convertibles. Prior to the start of the COVID-19 crisis, issuance for 2020 was projected to approach $59 billion, up from $53 billion in 2019. That growth could accelerate as crisis-battered companies seek affordable sources of funding.
Transparency and best execution requirements imposed by MiFID II in Europe caused e-trading platforms there to attract users and liquidity. Last year in Europe, 36% of institutional convertible bond investors were trading convertibles on multi-dealer electronic platforms, and users of these systems were executing nearly half of their overall convertibles trading volume electronically. In the United States, only about one in five institutional convertible investors were using multi-dealer e-trading platforms. However, users expected to ramp up their activity on these systems rapidly—to 45% of overall convertibles trading volume from the current 21% in the next one to two years—and overall adoption rates are accelerating.
Potential to Cut Trading Costs in Half
Convertibles investors are adopting e-trading for a simple reason: it tightens spreads and lowers trading costs. Bid-ask spreads on convertible bonds are usually wider than those on corporate bonds, and can vary significantly from dealer to dealer due to complexities in establishing valuations for specific convertible issues, which share characteristics of bonds and options, and many of which are unrated.
A new Greenwich Report, Crossed, Locked and Loaded: Trading Convertible Bonds, presents the results of a detailed examination of aggregated convertibles trading data from Tradeweb, which proves definitively that using the RFQ protocol on multi-dealer e-trading platforms can improve spreads dramatically. This is because the RFQ protocol has a unique capacity to transform uncertainty about the valuations of individual bonds into tighter spreads for users, a phenomenon explained in detail in the paper and supported by a robust dataset.