Bullish Bond Investors Return, But Can They Execute?

How AI Can Help Investors Profit in Illiquid Bond Markets

In 2022, bond investors have suffered what will likely be the worst year for bond price performance on record, so one might expect them to be a bit gun-shy. And yet, they seem to have been taking a more bullish stance into the end of the year 2022, with EPFR reporting inflows of $16 billion into U.S. bond funds in the first three weeks of November. 

At the same time, both the Bloomberg Euro Aggregate Corporate Total Return Index and the Bloomberg US Corporate Total Return Index are up substantially from their October lows. In October, the Euro Index was down almost 16% from the beginning of the year but is now down only 11%, and the US Index is down over 13% after being down nearly 21% in late October 2022.

This improvement in the market has been attributable to spread tightening in addition to an improvement in the government bond markets. Overbond uses AI to aggregate bond data and produce consolidated tape-like data series for EUR and USD bond transactions. Spread data derived from these series shows that 10 out of 12 corporate industry sectors saw tighter spreads at the end of November than at the end of October 2022, with tightening ranging from 5 basis points for financials to 41 basis points for real estate, for example.

Corporates Are Healthy, But The Outlook is Risky

Corporate issuers took advantage of low rates in recent years to shore up their balance sheets and are in relatively good shape. We’re not in the midst of a credit crisis and the economy hasn’t entered a recession. But the outlook isn’t as rosy. It’s widely assumed that Europe and the U.S. are facing recessions in 2023, and the yield curves in these regions reflect this expectation, with inversions―where yields on short-dated bonds are higher than those of long-term bonds―at depths not seen in decades.

S&P Global Ratings expects 12-month trailing default rates on high yield bonds to reach 3.75% if there’s a shallow recession and warns they could reach 6% if there’s a deep recession. Analysts at S&P point out that either scenario represents a substantial increase in the default rate from the previous year, and both would be above the 10-year average of 3.1%.

Investors Seek Yield at Higher Credit Quality

Many investors may have decided that the upside potential for bonds outweighs the downside risk at the current prices. Others, with a more defensive view, will be looking to rebalance their portfolios and move into more defensive industries or issuers with better credit fundamentals within the investment grade universe. In the current environment of high yields, bond investors can switch from riskier high yield bonds to investment grade bonds with stronger credit fundamentals and still maintain their target portfolio yield. For many investors, new issuance is the first choice for adding credit, but sourcing bonds this way may prove problematic in the near term.

Although issuance was close to its historical norms in November, it’s expected to dry up in December, and many expect it to remain light in 2023 as issuers are hesitant to pay the high coupons needed here. On the other hand, investor demand is expected to remain robust as investors rebalance their portfolios in line with the higher yields available from investment grade bonds. This mismatch between supply and demand will force investors into the secondary market, where they will face liquidity challenges as they sell lower-rated current holdings and buy available inventory in higher-rated bonds.

New AI Tools Increase Trader Confidence

It's a new environment for most bond investors, but thankfully, new tools exist to help with bond due diligence and trading. AI, for instance, can help investors determine the best executable price and liquidity risk for a bond, even if the bond is rarely traded.

The first tool in the AI toolbox is data. AI can ingest, process and aggregate data from disparate and incomplete sources to create a consolidated tape-like series of bond transaction data. This is particularly useful in Europe, where no consolidated bond transaction record—such as TRACE in the U.S.—exists. But it also helps mitigate the shortcomings of TRACE, where the data is only available with a lag and trades over a specific size are masked. 

Serverless cloud computing and parallelization—which breaks up large computational tasks into pieces that are solved simultaneously—provide computational speed and power that allow AI-generated price estimates to be available in near real-time. And this can be done for highly illiquid bond issues—providing essential insight for investors searching the secondary market for potential holdings.

AI can also be used to assess the liquidity risk of a bond. This is useful for evaluating potential new additions to the portfolio and monitoring individual security and total portfolio risk as market conditions change. Additionally, it’s invaluable information for choosing buy and sell candidates for rebalancing.

There’s no doubt that investors will find AI an indispensable tool in the current market environment. With its ability to help assess illiquid issues, investors can execute strategies more confidently than ever possible and take advantage of current market conditions.