In the fallout from the subprime crisis, exchanges have an opportunity to inject transparency into the fixed income market.

Investors used to perceive fixed income securities as something to be bought and held in their portfolio until maturity. Now, however, these instruments are actively traded to generate an absolute return just like any other asset class. Moreover, the strong derivatives market allows investors to hedge cash market risk. While the fixed income market is mainly traded over-the-counter (OTC), market dynamics are opening up new opportunities for exchanges.

Some of the growth in the fixed income market is being driven by newly developed countries such as India and China. Economic success in these regions has led to a surplus in personal savings. Lacking a broad range of investment alternatives, people have put their money in fixed income securities.

As the demand for fixed income securities has increased, particularly on the long end of the curve, government issuance has decreased in most countries except Japan. Long-term interest rates have fallen to artificially low levels, which has caused yield curves to flatten and sometimes invert. To many analysts, that signals a recession. “That aspect might be self-fulfilling,” warns Olof Manner, Senior Vice President for Fixed Income at Öhman Bank in Sweden. “It’s a case of which comes first, the chicken or the egg.”

In his view, corporate bonds and index-linked products will benefit in a weaker, high-inflation economy. Companies will issue high-yield bonds instead of equity.

Until recently, structured products such as collateralized debt obligations (CDOs) have been among the fastest growing segments of the market. But the subprime crisis in the US led to an implosion of that market, and it will be some time before CDOs reappear.

In the aftermath of the debacle, regulators are keen to find ways to improve market transparency. Fixed income trades are mainly transacted OTC, so pre-trade transparency is low in most segments. Investors call some dealers to get a price indication and a quote before trading. Post-trade transparency is generally better than in the pre-trade space, but dealers still need a more efficient way to report trades. Some authorities are talking about establishing central counterparty clearing facilities where they do not exist already. This would enable banks to reduce default risk as well as avoid credit crunches. “In the future, exchanges can play a key role in creating liquid markets as well as collecting and publishing fixed income trade data,” says Erik Thedéen, Head of Fixed Income at OMX. “The upside potential for exchanges is enormous.”

The exchange-traded fixed income derivatives market is serving as a proxy for cash bonds, which are in short supply. Fixed income derivatives, along with equities and equity derivatives, are among the most active exchangetraded products. The futures and options contracts on US T-Notes and T-Bonds and German Bunds, Bobls and Schätze are extremely liquid.

Ultimately, the rise in the global demand for fixed income products, lower government issuance and the need for more market transparency bodes well for exchanges. Going forward, they can leverage their success in fixed income to launch new contracts to satisfy the needs of investors looking to fill the gaps in the cash market.

By Sherree Decovny