Going with the flow
Trading capability, including a willingness to deploy balance sheet to support client needs, has long been a major differentiating factor for ANZ’s all-conquering fixed-income business. A group of the bank’s traders gathered to talk about 2020 at a KangaNews roundtable, including views on the extraordinary circumstances of the year and how liquidity may be affected for some time to come.
Left to right: Rakesh Jampala, Ian Ravenscroft, Sarah Valente, Chris Khan, Glenn Woodward
TRADING IN 2020
Davison 2020 has of course been an extremely challenging period for fixed-income market participants, including in the secondary market. How has ANZ’s trading function sought to navigate these conditions?
JAMPALA Perhaps even more so than during the financial crisis, the period beginning in March – punctuated by a complete deterioration in bid-side liquidity – presented great challenges for the market and indeed our business.
However, during the period when markets froze and a number of participants stepped back, ANZ was able to remain active in the provision of risk transfer and warehousing. This was possible in no small part because our domestic fixed-income operation is at the very core of our institutional and markets businesses.
Our bank-wide purpose is to help shape a world in which people and communities thrive. Helping the government finance itself and establish COVID-19 support programmes – via tender takedown and duration-management support – and providing liquidity to our clients in stressed situations goes to the heart of this purpose. We are proud to have delivered in this respect.
Davison How does fixed-income trading fit into the markets operation at ANZ in such a way that facilitates the kind of customer support you have been able to offer in 2020?
JAMPALA The strength and expertise of our trading operation and our full-service bond proposition across credit, SSAs [supranationals, sovereigns and agencies], and government and semi-government bonds generates a compelling value proposition. A secondary factor – but one that might have been more important during the period of stress – is our strategic focus on being a major risk-transfer participant.
Our strategy is predicated on being able to help our clients with the big trades and warehouse large amounts of risk. Having this skill set and appetite in our trading team was a major element of being able to support the market during the most difficult period.
In at the deep end
If crises are career-shaping events, 2020 provided young traders with a lifetime’s experience in just a few months. Sarah Valente is newer to the business than many of her veteran colleagues. She shares a view on learning to swim in rough waters.
VALENTE It has been a unique and exciting year. I think the team has navigated the challenges exceptionally well and I feel very fortunate to have joined the bond-trading team at a time when government and semi-government bonds are at the forefront of conversation, with market moves similar in many ways to those of the financial crisis.
I’m glad to have had the chance to witness and be a part of history in the form of the AOFM [Australian Office of Financial Management]’s unprecedented borrowing programme and the RBA [Reserve Bank of Australia]’s first QE programme.
These circumstances have helped me quickly learn the nuances of managing a bond book and have allowed me to be involved in team conversations about topics I never thought we would be discussing – like negative rates and the impact of economic shutdown.
Davison How did Australian dollar rates liquidity hold up in the worst of the COVID-19 crisis? Were there times when liquidity was challenged on an outright basis – that bond sellers could not get a price at all – versus prices being available but unattractive?
RAVENSCROFT Australian dollar liquidity held up very well until late February, when it became clear that COVID-19 had begun to spread through continental Europe and the risk-off tone began to accelerate. At this time we began to experience major portfolio redemptions across all geographies.
The search for bid-side liquidity led investors to ACGBs [Australian Commonwealth government bonds] as the way to raise cash, as the asset class with the best depth of liquidity in the Australian market. This gathered pace through early March and dealers’ ability to warehouse risk clearly became exhausted. ACGBs began to underperform materially versus US Treasuries and also, on a domestic basis, relative to the corresponding bond future.
The best demonstration of this underperformance was in the 10-year bond basket. The basis between the 10-year future and the bonds from which it is derived was trading at 10 basis points just days before the futures roll. The main driver of this move was offshore redemptions: sellers that were agnostic to the basis and had little option but to access what liquidity was left in Australian fixed income.
Davison What about liquidity in other Australian dollar asset classes, specifically local semi-governments and the Kangaroo SSA sector?
RAVENSCROFT This particular liquidity crisis was driven by a rush to raise cash in order to de-risk fixed-income portfolios. The sharp downturn in confidence had a negative impact across all Australian dollar asset classes but ACGBs were clearly the most affected sector at the peak of the crisis.
There was an 80 basis point underperformance in 10-year ACGB versus US Treasury spreads from mid-February to mid-March, coupled with a 13 per cent sell-off in the Australian dollar itself over the same period. This demonstrated the pace at which investors were moving back to the relative safety of the US dollar market.
Semi-government spreads widened sharply on relatively light outflows, but lack of liquidity in the sector actually drove clients further into selling the more liquid ACGBs.
There was little liquidity available in SSAs in meaningful size, at least beyond very short-dated bonds. While spread movement here was similar to that seen in semis, the sector’s bid-offer spreads were wider yet.
Perhaps even more so than during the financial crisis, the period beginning in March – punctuated by a complete deterioration in bid-side liquidity – presented great challenges for the market and indeed our business.
Davison How did March 2020 compare with previous crises going back to the financial crisis?
KHAN I think it’s important to note that the COVID-19 pandemic has been, first and foremost, a tragic health crisis that immediately affected the health and economic wellbeing of people on a scale none of us has witnessed before. As a liquidity event for Australian dollar bonds, it was of equal or even greater magnitude than the financial crisis.
However, unlike the financial crisis it was not driven primarily by concerns of default risk. Instead there was an abrupt and violent withdrawal of liquidity, and subsequently volatility.
At the same time, the upheaval to the traditional workplace added further pressures – and still does, unfortunately, for many of our clients and colleagues.
WOODWARD The reduction in liquidity in the ACGB and semi-government market happened in a much more compressed timeframe in March 2020 compared with the financial crisis. Bid-side support for semi-government paper effectively disappeared as domestic and offshore holders attempted to liquidate positions.
On the other side, the return to normal market conditions was also quicker than during the global financial crisis. The intervention of the RBA [Reserve Bank of Australia] was a major driver and injected much-needed confidence.
Davison Was restoring confidence, and thus liquidity, as simple as the story of the RBA stepping in to backstop the ACGB and semi market, and thus trading function returning?
RAVENSCROFT RBA bond purchases and the government’s crisis-response package were undoubtedly the key catalysts for the improvement in liquidity conditions. The first RBA purchase came on 20 March, just one day after the flash crash in Australian bond futures that could have ushered in a new wave of Australian dollar-specific risk-off tone.
Instead, A$27 billion (US$19.4 billion) of ACGB and semi-government bond purchases from 20 March to the end of the month saw a material correction in EFP spreads and a significant return of market confidence.
The normalisation of bid-offer spreads through April was also key in securing confidence. Secondary-market volume remained below average. But clients were able to access two-way markets in large volume from mid-April onward, from a wider selection of dealers that started to return to the market more actively.
Our aim was to maintain transparent communication with our clients – not just about our view on the market but also our capacity to warehouse risk. At the deepest point of the crisis, broking bonds was not an option given one-way client flow and zero interbank liquidity. This left a very limited pool of dealers able to warehouse risk.
Davison Did you see other dealers pulling back from the market? In this context, how was ANZ able to stay active during the period of disruption when others were not?
RAVENSCROFT It became evident as early as late February that liquidity provision had begun to pull back. We had to consider our own liquidity offering through this challenging period, which meant – more than ever – aligning our risk-taking with our clients’ liquidity requirements.
The message from our management was to continue supporting our clients through this unprecedented crisis. I think back to what proved to be our last team meeting before we enacted BCP [business-continuity planning] procedures that saw the trading team separated for what ended up being six months. The clear message then was to support our customers, first and foremost.
Our aim was to maintain transparent communication with our clients – not just about our view on the market but also our capacity to warehouse risk. At the deepest point of the crisis, broking bonds was not an option given one-way client flow and zero interbank liquidity. This left a very limited pool of dealers that was able to warehouse risk.
Recycling risk was incredibly challenging but we were, at times, able to find pockets of demand that allowed us to provide liquidity without materially increasing our balance-sheet exposure. Keeping sellers aware of where liquidity existed allowed them to achieve best execution despite the challenging market backdrop.
Davison How significant an impact has the massive increase in ACGB supply – including more frequent and larger Australian Office of Financial Management (AOFM) syndications – had on the dynamics of the Australian secondary rates market?
RAVENSCROFT Market conditions in ACGBs continued to improve throughout April, to a point where liquidity was arguably back – or at least close – to pre-COVID-19 levels. This allowed the AOFM to start tackling an increased issuance programme. Buyers began to reappear in quite large volume from early April, noting the shift in ACGB relative value on a global basis.
The first AOFM syndication in this period came on 15 April. By this point investors were actively seeking the offer side of liquidity – which had been significantly reduced by the volume of QE purchases. The book size of all five AOFM syndications since then tells a story about global demand for ACGBs as we emerge from the COVID-19 crisis.
What has stood out to me as a market maker during this period of supply is the lack of switching activity. ANZ has been a lead manager on four of the five AOFM syndications and these transactions have seen offshore investors allocating to Australian fixed-income product rather than switching on the curve. Even domestic investors, which had taken defensive positions in short-term cash instruments, were now shifting back to the ACGB market.
The unintended consequence of the TFF is a significantly smaller Australian dollar credit market in the short-to-medium term. It will bounce back after these policies are unwound – the major and regional banks will resume issuance, and offshore borrowers will return. But it will be a period of consolidation for 18 months to two years.
Davison What was the story for liquidity conditions in the Australian credit market during the early part of the crisis?
KHAN The liquidity story was very similar to the financial crisis in many respects, and far worse than any of the smaller crises in the intervening time. There was no imminent threat of financial institutions collapsing on this occasion, but trading conditions very quickly came to resemble that period. By this I mean large-scale liquidation – often of the highest-grade bonds, because they were the easiest or only ones clients could sell.
What differentiated this crisis was the speed of the widening but also of the subsequent recovery. This was driven by government support but also by a quicker response from market participants – in particular those conditioned by the financial crisis.
The only meaningful liquidity in the Australian credit market was in bank senior paper followed by – to a lesser degree – in repo-eligible regional banks and offshore financial institutions. These were therefore the bonds clients reached for to sell if needed.
These bonds also had a backstop bid: at some point the large bank balance sheets and asset managers would step in to buy. At the same time, if needed the RBA would offer these issuers emergency liquidity through the committed liquidity facility or other mechanisms.
Liquidity in tier-two bonds and corporates was, to say the least, very challenging – particularly for corporates. This is because it became necessary to evaluate default risk as well as liquidity risk.
Davison How did ANZ approach this period?
KHAN We always endeavoured to show a bid even though, much like the buy-side community, we had no way to predict where the turning point in the spread market might be. There was also no interbank market into which we could sell risk. We were pricing at-risk bids and, when hit, taking bonds onto the trading book.
Like most market participants, there were no easy days for us during the worst of the crisis. We run an at-risk trading book and significant inventory – unlike quite a lot of banks it is not a solely brokered model. Our model brings significant P&L volatility. But, rather than shut up shop, we have a duty to try to assist our clients through these times.
This is with 100 per cent support of ANZ senior management in the markets business. They backed our call to keep making markets through the worst of the crisis – and the decision proved to be the correct call.
We don’t have infinite liquidity as a trading book. Far from it – provision of liquidity is scarce and, in stressed conditions, we prioritise its allocation to clients with which we have long-term relationships and have successfully worked in the past. Looking back, I believe we fulfilled our duty.
Davison One of the particular challenges in the financial crisis was the overhang of bonds as investors had to sell to meet redemption pressure. How much forced selling was there this time round, especially as the government allowed early access to superannuation funds, and how did ANZ help manage it?
KHAN Superannuation-fund redemption and many clients’ rush for cash had a substantial impact on the credit market and, in particular, the major-bank senior curve. These floating-rate notes are a major component of many super funds’ short-dated holdings. Selling in this space was compounded by further selling by other investors as they were the only securities in which they could get large-sized bids.
This quickly resulted in the credit curve inverting – the short end traded wider than the five-year point at various times. Our role was to provide bid-side liquidity in what is – relatively – the safest of sectors. Again, ANZ management was very supportive when we required more balance sheet to support this flow. It ultimately resulted in March and April being the largest monthly flow ANZ has ever seen – albeit substantially weighted toward client selling.
The reduction in liquidity in the ACGB and semi-government market happened in a much more compressed timeframe in March 2020 compared with the financial crisis. Bid-side support for semi-government paper effectively disappeared as domestic and offshore holders attempted to liquidate positions.
Davison The biggest change in credit-market dynamics has been the absence of the major banks from new issuance. How has this changed secondary-market dynamics around overall liquidity and price discovery in particular?
KHAN The RBA’s term funding facility (TFF) has resulted in the largest and most abrupt change to the composition and dynamics of the Australian credit market ever seen. Due to the TFF, there very likely will be no major-bank or regional-bank senior issuance for an extended period. TFF cash has also driven strong investment demand for these bonds by banks themselves.
This has resulted in spreads collapsing to post-financial-crisis tight levels. Combined with the large ongoing redemption schedule, we have seen the largest segment of the Australian dollar credit market essentially grind to a halt. It is likely to stay this way for a matter of years.
With the major banks no longer frequently issuing offshore, the cross-currency basis swap has collapsed and made the Australian dollar market considerably less appealing for SSA and other Kangaroo issuers.
Traders and investors alike are being forced to focus on a significantly limited universe of investable credit, concentrated on corporate bonds, tier-two and securitisation. Alternatively, investors can expand their mandates to incorporate semi-government bonds or foreign-currency credit markets.
The focus on corporate and tier-two securities has created greater liquidity in these assets. My opinion is that this remains a bull-market phenomenon, however. Structurally, liquidity is unlikely to be significantly better in future periods of market stress – particularly compared with what we had come to expect in domestic financials.
Davison It has been a consistent talking point for the past decade that banks’ trading capabilities have been fundamentally altered by regulation and the consequent reduced capacity to warehouse bonds. How has ANZ navigated this challenge to continue supporting liquidity for clients?
KHAN It’s a similar story across the high-grade and credit sectors. The impact of Dodd-Frank and banks’ reduced ability to warehouse risk was evident to all in the crisis of March and April 2020. The lack of warehousing and an overreliance on broking severely affected the state of liquidity across markets.
ANZ principally runs an at-risk model, under which we warehouse risk and use our global distribution network to recycle it. Our sales team will look to broker risk when necessary but it’s not our primary approach.
Davison To what extent has the Australian dollar market diversified over recent years to provide more genuine two-way flow? It always used to be said that investors were either all buying or all selling at the same time. Has this changed?
RAVENSCROFT The breadth of investors in the Australian dollar market has grown in tandem with its increasing scale. For example, while some might point to a small drop in proportion of offshore holdings of ACGBs since the start of the year, the notional volume of these holdings is a more significant figure. This has grown substantially over the same period.
Big thematic moves like those we have witnessed this year will always lead to same-direction client flow. But we certainly see more two-way flow in less volatile periods nowadays. It is not just an onshore versus offshore dynamic, either. We have clients locally that trade with differing views on the market.
Davison We are looking at ultra-low rates and a lot more ACGB supply for the foreseeable future, with the RBA ready to step in if needed. How will these factors influence liquidity on an ongoing basis?
RAVENSCROFT The RBA has clearly indicated that it is prepared to support the bond market in times of stress. This will underpin investor confidence in ACGBs and semis as the issuers work through greatly increased funding requirements.
We are not immune to volatility shocks, but the likelihood of another risk-off scenario of the magnitude we saw in February and March is somewhat low in a market of coordinated central-bank stimulus on a global scale.
The Australian dollar bond market continues to offer good value to global investors across a number of metrics, including spread to US Treasuries and on an FX-hedged basis. Australia has also been commended for its management of the crisis from a health perspective.
My view is that offshore investors will continue to participate actively in our increased funding needs as they view the Australian market as one of the best investment opportunities globally.
It will be a low-yield environment overall. Combined with the smaller investable credit universe, this will result in investors diversifying further into the corporate market and into subordinated debt – including financials and the emerging corporate subordinated sector.
Davison There is a reasonably significant evolution coming to the Australian futures complex, in the form of a new five-year Treasury bond contract. What impact will this have on the cash market?
RAVENSCROFT The five-year futures contract is a key development for our market going forward. It is a very different proposition from the 20-year contract, which has struggled to become an active instrument. I think physical and derivative markets will react very positively to the five-year bond future, which also brings us more closely in line with international markets. It will certainly provide a more relevant hedge for ACGBs than the relatively anchored three-year bond future.
This can only be positive for liquidity. The opening up of a five-year bond basket provides opportunity for domestic participants that had largely been restricted to activity in 10-year bonds after the change in dynamic at the three-year point.
Davison What is the longer-term outlook for credit trading given the dynamic of little or no major-bank senior issuance?
KHAN I think a number of key themes will play out over the coming years. It will be a low-yield environment overall. Combined with the smaller investable credit universe, this will result in investors diversifying further into the corporate market and into subordinated debt – including financials and the emerging corporate subordinated sector. Investors with more flexible mandates will also look to add alpha in the semi-government and US dollar credit markets.
Davison Do you expect Australia to become a more rates-focused market in future, based on the drivers of more government-sector issuance, less credit volume and pricing dynamics working against Kangaroo issuers?
KHAN Undoubtedly. The unintended consequence of the TFF is a significantly smaller Australian dollar credit market in the short-to-medium term. It will bounce back after these policies are unwound – the major and regional banks will resume issuance, and offshore borrowers will return. But it will be a period of consolidation for 18 months to two years.
While the credit market is facing structural challenges, the ACGB and semi markets are seeing prodigious growth. Providing investors and issuers in those sectors with risk and distribution support is at the core of our focus in financial markets at ANZ.