The ‘equitification’ of credit

The writer is head of research at Barclays

A transformation is under way in the world of credit. On the one hand, new instruments and trading processes are improving the liquidity of public bonds and loans, and expanding the range of strategies available to investors. On the other, the private credit market has grown rapidly, from a funding source for small and medium-sized businesses into a legitimate alternative to public markets.

These are not separate trends. Instead, they are part of a broader structural shift we call the “equitification” of credit. It will have long-lasting implications for how issuers raise funds and how investors position across the credit spectrum.

Equity markets have long had two distinct segments. First, a very liquid public market, where transaction costs are low, due to the presence of centralised marketplaces and exchanges. Second, a well-developed private market that can fund businesses of all shapes and sizes, from start-ups to giant companies such as Uber, which went public at a valuation of more than $70bn.

Together, these markets offer a remarkable amount of flexibility for both investors and issuers. Investors in equities can use “bottom-up” strategies based on fundamentals, as well as quant investing and even high-frequency trading. They can also tailor exposures according to their liquidity needs. Investors who need access to funds quickly can traffic in the public markets, while those with longer holding periods can find opportunities in the private market.

Issuers, on the other hand, might prefer the limited disclosures of the private market, or the greater depth of the public market. Some will go public to finance their operations, such as biotech companies seeking to fund clinical trials. Others might use the public market to cash out after maturing under private control.

Historically, that array of options has not been available to investors and issuers in the world of credit. Public bond markets have long had sufficient capacity to finance large companies but the vast number of securities in circulation has meant liquidity in a particular instrument is often constrained.

The difficulty of “matching” buyers and sellers meant that trading was done over the counter, with much higher transaction costs. Investors were confined to fundamental investing — systematic strategies with high turnover were too costly to implement. In fact, trading was so expensive that bonds had a liquidity premium: yields to investors were higher because transaction costs weighed on returns.

This began to change in the 2010s with the advent of exchange traded funds dedicated to bonds. ETFs trade actively in the secondary market just like they do in equities, with very high liquidity. Barclays is an active participant in this market.

Mutual funds own these instruments so they can rely less on trading individual bonds, and thus reduce the drag of transaction costs on returns. More recently, market makers have made greater use of ETFs to hedge and price diversified bundles of bonds. According to Barclays’ estimates, these “portfolio trades” can reduce transaction costs by more than 40 per cent compared with trades in individual securities.

These new liquidity management tools have expanded the available investment styles, including the kind of automated trading strategies once limited to equities. And this is just the beginning. As new strategies are deployed, they generate trading patterns that could lead to the development of satellite markets, such as derivatives and swaps, that have long featured in equities.

The same developments are fuelling the growth of the private credit market. For less-active investors such as pension funds and insurance companies, public markets have become much less attractive. Yields have fallen, in part because that once-healthy liquidity premium has shrunk by more than 50 per cent, according to our estimates. Previously, these investors were effectively freeriding: they didn’t pay the high transaction costs and so were able to capture excess returns. Now, they need to turn to private markets if they want to get appropriately compensated for forgoing the ability to quickly transact.

More-active investors, meanwhile, can now tailor exposures to match their needs, turning to public markets if they need (cheap) liquidity or capturing excess returns in the private market. For issuers, the flexibility is even greater: companies can issue in both public and private markets, taking advantage of variations in terms and speed of execution. In such a world, asset managers need to adapt, or risk being left behind.