(Bloomberg) -- The algorithms that have grown more prominent in credit trading may pose a problem as volatility rises over the next few years, according to Wellington Management.
As mercurial moves in credit markets become more frequent, algorithms that help money managers make quick decisions about which corporate bonds to buy and sell could begin reacting more extremely, according to Masaya Okoshi, Wellington’s US investment-grade credit trading team lead.
But there are also opportunities to be found when the cost of liquidity quickly changes as volatility rises, says Connor Fitzgerald, fixed-income portfolio manager at Wellington.
The two, who work closely together with their teams to help manage Wellington’s more than $1.2 trillion of assets, spoke to Bloomberg in a series of interviews that ended on Aug. 28. Comments have been edited and condensed.
What risks are the markets not fully understanding right now?
CF: One big risk that we’re pretty focused on, and I think will matter at some point, but not sure when, is just how we think about continued very large fiscal deficits. This is the first year where there’s been a lot of coupon supply and there hasn’t really been any Fed buying to offset it. So, I think there’s still a learning experience ahead of us in terms of how the market will digest $2.2 trillion of coupon supply.
MO: In the next several years, there will be more credit dispersion and credit volatility. There is a much bigger community of electronic and systematic participants in our market and they were programmed during a period of relatively low volatility and credit dispersion. So, as both factors rise, a risk to the market is that there might be some exaggerated reactions from more of the electronic, algorithmic community that we haven’t seen in the past.
When those opportunities come in, say when the algorithms are not catching everything and there’s dislocation, how do you act on them?
CF: Essentially what you’re getting paid for when you buy a corporate bond is the default risk or the inherent credit risk, but there’s also the price of liquidity. And the price of liquidity can expand and contract dramatically when volatility picks up. So, there’s periods of time when there’s one market constituent that might have a significant outflow or one type of end-user client base and that can dramatically change the price of corporate bonds in a very short window.
But having this integrated investment process where we work very closely with the traders, basically being able to over communicate and act quickly and be aligned on what we’re trying to accomplish when the price of liquidity changes quickly, is something we think is different and adds value for clients, and seems to be happening more frequently as the market structure evolves.
What are you watching as a September rate cut becomes more imminent?
MO: What we’re following is what’s going to happen with the $6 trillion of money market assets that are being held. There’s a lot of corporates and a lot of individuals that are fine with keeping their cash at the bank when it’s earning above 5%, and I think that’s probably not going to last much longer.
So, I do think there will be a reinvestment of some of that historically high money market cash buildup into the market and that could again be technically supportive for credit. I don’t think one cut in isolation will affect reinvestments materially, but I think a series of cuts over the next several years could.
And lastly, what are your expectations for both issuance and market technicals for the rest of the year?
CF: I wouldn’t be surprised if a lot of company management teams, C-suite CFOs, are looking to get their refinancing needs completed ahead of the presidential election, because I do think there’s the possibility of election-related volatility in the fall. A lot of issuance this year has been heavily skewed toward refinancing. So, it’s not as if there’s a lot of net new issuance in the investment-grade market.
MO: The investment-grade market in the US will remain a safe haven, as we’re already seeing now. We’re seeing domestic flows remain consistently supportive, we’re seeing foreign flows remain consistently supportive and the net supply dynamic has been consistently supportive. So, while that can ebb and flow, we do think in totality that the supportive technical will continue.
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