Quants in the Muni Market Show Bond Liquidity Will Be Fine

(Bloomberg Opinion) -- At least one quantitative trading firm thinks it has finally cracked the code to the widely idiosyncratic, infrequently traded, largely individual investor-based U.S. municipal bond market.

Bloomberg News’s Martin Z. Braun has the scoop:

Headlands Tech Global Markets LLC, a firm founded by former senior executives at Citadel LLC, is using complex mathematical formulas and powerful computers to buy and sell state and local government securities, seizing on the sometimes divergent prices in a market where the vast majority of bonds only rarely change hands.

Headlands’ five-man band of algorithm-driven traders have become a major, if little known, force in the industry, bidding each day on about 13,000 municipal securities that are put up for sale on electronic trading platforms. That’s placed it among a group of companies that are bringing technology that has swept through other corners of Wall Street to state and local-government debt trading, challenging a long-held view that a market that finances everything from factories to state governments requires detailed research to gauge prices.

“This idea that every bond is a unique snowflake and a story — they say ‘balderdash’,” Paul Daley, a managing director at BondWave LLC, a financial technology company, said of Headlands’ approach. “All these bonds are mathematical equations, and if we can model it, we can price it.”

Maybe Headlands has built a rock-solid model. Most likely, it still has to work out a number of kinks. Either way, the fact that former Citadel senior executives are wading into munis is yet another sign that the debt markets are continuing to evolve more than a decade after the financial crisis, and it should provide some comfort that Wall Street’s diminished role in making markets won’t create a widespread liquidity crisis during bouts of volatility.

In many ways, the thought of muni quants would have seemed far-fetched just a few years ago. The $3.8 trillion market is mostly made up of highly creditworthy local governments, school districts and water systems, combined with a handful of speculative economic-development projects and the rare headline-grabbing defaults like Detroit and Puerto Rico. For a time in the wake of the financial crisis, it was one of the few Wall Street segments that actually needed more analysts

Now, the quant revolution felt inevitable. It has been almost two years since Citadel Securities began making markets for investors in all older U.S. Treasuries, an area of the world’s biggest debt market that had been largely exclusive to Wall Street banks. Fixed-income trading platform MarketAxess Holdings Inc. hired Chris Concannon, president and chief operating officer of Cboe Global Markets Inc., for similar roles earlier this year, a move that seems likely to bring sweeping change to how corporate-bond trading works with technology. 

Meanwhile, the way investors buy and sell bonds is changing along with how they’re traded. Exchange-traded funds are growing in popularity and adding an element of real-time price discovery that wasn’t publicly available before, causing even illiquid high-yield corporate bonds to fall in an orderly fashion during December’s market rout. Several asset managers have introduced fixed-income funds that tap into quant strategies like factor investing to strike a balance between active and passive offerings.

Headlands, based in Chicago, stands to make a tidy profit in munis if its technology holds up. As Braun noted, Wall Street dealers cut their muni holdings by about 60 percent since 2006. Headlands had an inventory of $400 million as of a year ago, which suggests plenty of room to grow and fill the void. At least for now, it’s focusing on small lots of bonds, in contrast to the larger banks that have traders work on blocks of more than $1 million. And, of course, every time the firm places a bid, its models get valuable feedback for next time.

At least for the foreseeable future, quants aren’t going to displace traditional fixed-income traders. Bonds — and especially munis — are by definition less homogeneous than equities and don’t lend themselves to perfect automation.  If, for example, an investor two weeks from now wants to buy a large block of Chicago general obligations based on the city’s runoff election for mayor, there’s no other way but to coordinate with a large bank, where relationships still win the day.

That doesn’t diminish the significance of Headlands, nor the other quants who have ventured into fixed income. They are taking risk, boosting overall liquidity and stepping in where Wall Street can’t. During good times, they’ll profit along with dealers and investors. In periods of tumult, they’ll probably all suffer losses together. In other words, it’s the logical system to evolve from post-crisis regulations aimed at avoiding excessive risk in the banking system. 

The market for Treasury futures is one exception. It has very high liquidity.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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