A More Informed Picture of Market Liquidity In the European Corporate Bond Market

MARKETAXESS

ONMARKETAXESS

MARKETAXESS BID-ASK SPREAD INDEX (BASI)™

MARKETAXESS ON is a forum for thought leadership and discussion on the subjects and issues that are shaping the evolution of electronic trading in the credit markets. With internal resources and third party experts, we are developing research, insights and ideas aimed at bringing new levels of innovation, connectivity and efficiency to the MarketAxess community of clients and dealers.

ONMARKETAXESS

INTRODUCTION

Regulatory changes are driving important shifts in the credit markets. The incoming

Basel III capital requirements are limiting dealers’ ability to hold risk-weighted assets,

such as corporate bonds, restricting their market-making abilities in those instruments,

and thus reducing credit market liquidity and turnover. Confronted by the challenge of

buying and selling bonds in these difficult markets, where opportunities for real return

are scarce and trading costs are increasing, investors are seeking a more informed

picture of market liquidity to help identify trading opportunities and reduce their

execution costs. The MarketAxess Bid-Ask Spread Index (BASI)™ was developed

to serve this need.

EMPOWERING MARKET DATA

MarketAxess Research developed the European BASI as a way to quantify European corporate bond market liquidity. This new approach enables a comparison of the prices quoted for actively traded bonds over time. The development of the index was made possible by access to more detailed Eurobond trade data following MarketAxess’ acquisition of Xtrakter Ltd. in 2013.

Xtrakter is a leading provider of capital markets data, operational risk management, trade matching and regulatory reporting services to the global securities market. Under the Markets in Financial Instruments Directive (MiFID), Xtrakter is an Approved Reporting Mechanism (ARM) to the UK Financial Conduct Authority (FCA) and other European regulators. In 2013, Xtrakter processed 1.12bn transactions on behalf of its user community and published pricing data on over 69,000 bonds. It processes approximately 65% of fixed income transactions reported to the FCA.

As there is currently no consolidated trade tape in Europe that is comparable to FINRA’s Trade Reporting Compliance Engine (TRACE) in the United States, many of our investor and dealer clients have expressed interest in data that can increase the transparency of the Euro and Sterling bond markets. This, in addition to the rising demand for more efficient execution, better tools for transaction cost analysis, and new measures of market liquidity led MarketAxess to develop its proprietary index.

.

2

A New Way to Measure Market Liquidity in the European Corporate Bond Market

The MarketAxess Bid-Ask Spread Index (BASI)™

Today, many of the world’s largest asset managers use the BASI as a barometer of transaction costs as well as a snapshot of overall market liquidity.

LIQUIDITY AND THE CORPORATE BOND MARKET

Liquidity is a measure of the ease with which a bond

can be traded and can be approximated by the overall

cost of trading the bond. In over-the-counter (OTC)

markets such as corporate bonds, the cost of trading

is defined primarily by the difference (‘spread’)

between the price at which a broker-dealer is willing

to buy a bond (‘bid’) and the price at which it is willing

to sell (‘ask’ or ‘offer’) the same bond. In addition to

the credit risk associated with holding a particular

bond, the bid-ask spread is related to the length of

time a broker-dealer believes it will have to hold that

bond before selling it.

In order to facilitate fixed income trading for its

institutional investor clients, a broker-dealer can

either act as an agent or as a principal for a trade.

An agent-based transaction is effectively risk-free for

3

the dealer, as it seeks to find the opposite side of

an investor-initiated trade and then execute both legs

simultaneously, incurring little or no market exposure.

Working as an agent, the dealer does not hold the

bonds on its balance sheet, freeing it from having

to commit capital.

However, because of the illiquid nature of the corporate

bond market, when on a typical day a relatively small

number of bonds trade with any frequency1, dealers

traditionally act as a principal. In a principal-based

transaction, the dealer executes a single side of

the trade and, in many cases, holds the bonds until

the other side of the trade is found at a later date.

During this period, the dealer is subject to changes

in the market prices of the bonds it holds and will

price trades accordingly, thereby passing along a “risk

premium” to the client for effectively renting its balance

sheet. As such, the bid-ask spread serves as a proxy for

corporate bond market liquidity.

A NEW WAY TO MEASURE LIQUIDITY

Tracking bid-ask spread movements is straightforward

for individual bonds. However, for the purpose of an

index, aggregating the bid-ask spread of multiple

bonds to accurately represent the market as a whole

is challenging. Most fundamentally, which bonds do

you select when the majority trade infrequently? How do

you weight each bond’s bid-ask spread against others?

At what frequency do you recalibrate the index?

The approach of the MarketAxess European BASI takes

into consideration these and other factors to create an

index that accurately tracks overall credit market cycles.

CREDIT MARKET CYCLES AND THE BASI

The bid-ask spread of a bond fluctuates according to

the issue’s creditworthiness and changes in market

The MarketAxess European BASI tracks

all of the bonds with trades reported to

Xtrakter over a given time period. The

spread difference between buys and

sells is calculated for every bond with

reported trades, and then an average of

the differences is calculated to represent

an estimate of the day’s aggregate bid-

offer spread.

Daily point estimates are then used to

calculate an implied index value using

a LOWESS-procedure, a commonly

used regression modeling method that

stands for “locally weighted scatterplot

smoothing.” On days when less than one

percent of the constituent group can be

priced, the index is not calculated.

METHODOLOGY

1On average, only 18 bonds trade on both sides (i.e. bought and sold) 10 times or more each day, representing just 12% of the overall daily trading volume for U.S. high-grade bonds. (Source: MarketAxess Research)

4

THE EUROPEAN BASI

volatility. The BASI, as a broad indicator of market liquidity

and implied transaction costs, allows us to observe and

explore these relationships further.

Under normal market conditions, when dealers can use

their balance sheets freely to support market making

for clients, the bid-ask spread is generally narrower,

reflecting both a lower inventory risk for dealers and

lower trading costs for investors. However, during periods

of increased volatility, dealers tend to buy at lower prices

and sell at higher prices, and bid-ask spreads tend to

widen reflecting the increased risk and transaction costs.

HISTORICAL BID-ASK SPREADS

The MarketAxess BASI typically reflects broader credit

market cycles. When looking at historical bid-ask spread

data, there is a fairly clear correlation between the index

and specific events or periods where risk-taking by

dealers and investors has been impacted. For example

during the credit sell-off in the early summer of 2013

the European BASI widened out reflecting greater price

volatility in the market.

We can also use the European BASI to compare transac-

tion costs across markets. The Euro high-grade (HG) BASI

is tighter than the Euro high yield (HY) BASI indicating that

– as expected – trading costs in the HY market are higher

than the HG market. A similar pattern can be observed in

the sterling market. Interestingly you can also compare

across markets and currencies, for example to see how

much lower trading costs are in Sterling denominated

HG bonds as opposed to Euro denominated HY bonds.

ADDITIONAL APPLICATIONS OF THE BASI

The MarketAxess BASI can be created for specific

market sectors, trade size categories and credit

products, including U.S. high-grade bonds (USHG),

HY bonds, emerging markets bonds and most recently

euro and sterling-denominated corporate bonds.

The index can also be calculated on a daily, weekly,

monthly or quarterly basis. The European BASI helps

market participants identify pockets of liquidity where

opportunities to trade bonds more efficiently and at

lower costs might be revealed.

The European BASI has been

calculated for both euro and

sterling corporate bonds,

in high-grade and high yield.

By comparing the two currencies

we can see, for example, that

the euro BASI is much tighter

than the sterling BASI,

reflecting a larger market in

euro-denominated bonds and

comparatively better liquidity.

IN SUMMARY

Given market structure changes brought about by regulations and a market environment where opportunities

to improve yield are scarce, institutional investors are more challenged than ever to actively manage their

bond portfolios. According to MarketAxess Research, liquidity is concentrating around a relatively small

number of more recent ‘benchmark’ issues, or large new issues from well-known companies. These bonds

tend to be more liquid, trading with greater frequency and tighter bid-ask spreads. Investors wanting to trade

bonds that fall outside of this category, however, face a market that is less liquid and highly fragmented,

where transaction costs can represent a greater percentage of their real returns. In such an environment,

a new way to measure market liquidity is welcome.

The MarketAxess BASI offers institutional investors a more informed picture of overall market liquidity.

The BASI can also serve as an important tool in an overall strategy to help drive trading and cost

improvement strategies.

The MarketAxess BASI is available at: www.marketaxess.com/Research/BASI

45

40

35

30

25

20

15

10

5

0

3/5/20

01

3/5/20

02

3/5/20

03

3/5/20

04

3/5/20

05

3/5/20

06

3/5/20

07

3/5/20

08

3/5/20

09

3/5/20

10

3/5/20

11

3/5/20

12

BASI (based on MarketAxess trade data) MarketAxess BASI (based on TRACE data)

The chart shows two variations of the MarketAxess USHG BASI, for which we have data going back several years. The BASI chart in gold dating back to 2001 is plotted using MarketAxess trade data and represents the average bid-ask spread just for electronic trades on the MarketAxess platform over the period. The BASI chart in blue, starting in 2008, is compiled from TRACE data and represents the average bid-ask spread in the market as a whole. The difference between the two charts is equivalent to the difference in bid-ask spread achieved through electronic trading compared to the spread in the overall market. It is clear by comparing these two indices that consistently tighter bid-ask spreads are achieved when trading electronically.

THE BASI AND E-TRADING

5

For more information, please contact:

Alex SedgwickHead of Research+1.212.813.6078

Visit our website:marketaxess.com/Research/BASI

©2014 MarketAxess Holdings Inc. (the “Company”). Confidential and proprietary information of the Company. None of the information contained herein may be excerpted, copied, disseminated or otherwise disclosed to any other person without the Company’s express written consent.

MarketAxess Corporation, member FINRA and SIPC. MarketAxess Europe Ltd. and Xtrakter Ltd. are regulated by the Financial Conduct Authority.