A Changing Landscape

The structure of fixed income markets has changed dramatically over the past decade. New regulations, government bond purchase programs, new products such as ETFs, the emergence of electronic all-to-all platforms and non-dealer liquidity providers using algorithmic and high frequency trading are among the developments making it more difficult for sell-side fixed income desks to remain profitable.

After the 2008 financial crisis regulators around the world recognized the need to create a safer banking system. Regulations increased capital requirements, reduced the risk banks are allowed to take and increased costs for intermediaries. The unintended consequence of these new regulations has been a reduction in liquidity in the secondary bond market. Dealers are less willing and less able to hold inventories and so they are less willing to act as a principal in bond trading.

The current sell-side trading desk process

Sell-side dealers and buy-side asset managers are rapidly embracing AI applications to price fixed income securities algorithmically in a live trading environment or for end of day reconciliation. Among these is the credit trading desk at Dekabank, a German financial institution, which was introduced to Overbond through Infosys Consulting. Overbond analyzed Dekabank’s credit trading process and determined how it could be improved with the integration of an AI bond pricing model. Under the legacy Dekabank credit trading process traders received RFQs by one of two processes:

The legacy challenge: low confidence in prices

These factors lead to low confidence in the suggested prices and traders must constantly spend a great deal of time and effort in manually adjusting prices based on prior knowledge and intuition. The major trade-off is thus accuracy versus time, leading to missed deals and direct downward pressure on desk P&L.

The solution: AI-powered bond pricing

Need for centralization of information

AI modeling techniques share many similarities with classic statistical modeling techniques. Statistics provides the building blocks upon which the machine learning that drives AI is built and both use large amounts of data. But statistics is purely mathematical and largely descriptive with some ability for inference. AI adds additional programming, made possible with modern computing power, to move one step beyond statistics and become predictive.

The goals of the two methods are different. Statisticians start with a set of known assumptions that are given to the model and best explain the expected behavior of the financial outcome in consideration. With AI techniques the underlying assumptions are unknown and the aim of the model is to determine itself the method that best predicts the outcome in consideration.

Overbond has harnessed the AI advantage for pricing bonds

Corporate and Government Bond Intelligence (COBI)-Pricing was created as part of Overbond’s suite of AI algorithms for the fixed income capital markets. It algorithmically finds the optimal indicative new issue bond prices and secondary market bond prices for global investment grade (IG) and high yield (HY) bonds, using machine-learning (ML) algorithms. The ML algorithms analyze millions of data points related to factors such as historical pricing trends between similar bonds and similar issuers, intra-day pricing volatility, trading volume and counterparty composition, company fundamentals, investor sentiment and industry, rating or tenor cluster comparables. Data is aggregated from multiple types of data sources including:

The solution: Overbond COBI-Pricing Live

Overbond’s COBI-Pricing LIVE is a customizable AI pricing engine that assists traders in automating pricing and trading workflows for global investment-grade bonds. It generates prices and liquidity scores for more than 100,000 fixed income instruments and builds curves for more than 10,000 issuers in various real-time liquidity scenarios.

The full interoperability of COBI-Pricing LIVE allows its AI algorithms to ingest, aggregate and process data from live and historical vendor feeds, internal historical records, OTC settlement layer volume records, and now voice transactions. Overbond AI pricing, liquidity scoring, LIVE trading automation and routing algorithms can now capitalise on all primary and agency trading routes, voice or electronic, across all venues and counterparty types.

COBI-Pricing LIVE has a refresh rate of less than three seconds, enabling sell-side trading desks to fully automate 30% of their RFQs and execute an additional 20% with trader supervision. COBI-Pricing LIVE allows traders to automate trade flow, improve liquidity risk, improve price monitoring and reporting, respond to 80% to 120% more RFQs, maintain an optimal hit ratio and significantly increase desk P&L.

The solution: the Overbond COBI-Pricing algorithm

The solution: COBI-Pricing data intake

Successful data pre-processing is the key stage and a pre-requisite for operation of the COBI-Pricing algorithm. The precision of the algorithm output is critically dependent on the accuracy, timeliness, and relevance of the pre-processed input data. Overbond sources raw data from major data suppliers in the financial sector, including Refinitiv, Ice, The Six Group, EDI, MarketAxess, Tradeweb, Euroclear, Clearstream, DTCC, CDS, S&P Global Market Intelligence, major credit rating agencies, as well as other sources. The data COBI-Pricing algorithms uses includes the following:

The P&L enhancement: margin optimization AI model

Margin is dynamic: training for bond availability and risk

The Overbond margin optimization model adjusts to the desk's approach by adapting margin based on the availability of a bond in the market and a market risk tolerance.

CMAC: A breakthrough in bond trading risk analysis

The model uses case-mix adjusted cluster (CMAC) analysis to separate country, sector, issuer and issue-specific risks in bond prices and isolate market conditions through time.

CMAC is used to group similar observations into a group or cluster. So, for instance, all bonds whose prices rise when oil prices fall might be lumped together irrespective of their other characteristics.

But there are hundreds of dimensions that affect bonds. For instance, bonds sensitive to oil prices could include bonds from airlines, manufacturing or trucking, have multiple maturities and be rated differently —the number of clusters of like attributes can quickly become staggering.

The implementation: project structure

Overbond structured a project implemented for a large European bank into two phases. Overbond first deployed and tested end-of-day data on a smaller universe of ISINs to which ML algorithms were applied to find the best executable secondary market bond price for each bond.

Intra-day pricing was approached as a Phase 2 deliverable of the project because Overbond ML algorithms analyze millions of data points aggregated from multiple data sources and the models are computationally intensive.

The implementation: back-testing simulation

A back-test was conducted for a sell-side trading desk that trades in Euro and USD. The trading performance of the Overbond model was compared with the record of the trading desk without AI assistance.

All RFQ volumes traded in Q2 and Q3 in 2022 were compared, which included 7,551 accepted (and accepted but tied) RFQs and 7,190 covered (and covered but tied) RFQs on both the bid and ask sides.

The trades were filtered to include only 9,704 trades that involved senior unsecured corporate bonds, of which the trading desk accepted 5,083 and the model accepted 3,018.

The margin optimization model was optimized for maximum profit capture or minimum distance-to-cover, so the prices produced by the model would be expected to be closer to cover than those quoted by the trader.

The cost of margin for each trade was measured as the distance to cover (in cents) multiplied by the size of the trade (in Euros).

The model additionally looks at the rejected RFQ’s and based on the proportion falling into the Tier 1 category (the most liquid bonds) then performs a scenario analysis to determine the potential opportunistic P&L capture.

The above table shows the scenario analysis for actual Q2 - Q3 2022 data, along with 3 additional scenarios to highlight the potential variance for portfolios with differing numbers of Tier 1 categorized bonds.

Assuming a mid-range 40% increase in hit rate for the book in question, the trader would expect to see an opportunistic annualized P&L gain of over EUR 2 million.

The implementation: the user interface

Overbond normally outputs by API but results can also be displayed on the Overbond user interface. The figure below shows how the results would appear to a trader using the Overbond UI front-end platform.

The columns “Margin Bid (M)” and “Margin Ask (M)” are composed of the “distance to Bid (M)” and “distance to Ask (M)” respectively, on top of the COBI priced “Bid” and “Ask” quotes for each bond.

The business impact

Overbond has created positive business impact for clients around the globe, including sell-side institutions with significant trading volumes (200-500 RFQs+ a day per trader). We work with clients’ innovation groups to actively explore the application of new technologies that can serve as the catalyst for trading automation and improved risk management, trade flow, pre-trade and post-trade analytics. These technologies have direct business benefits.

Implementation considerations

About Overbond

Overbond is a developer of process-redefining, AI-driven data and analytics and trade automation solutions for the global fixed income markets. Overbond performs market surveillance, data aggregation and normalization, and deep AI quantitative observation on more than 100,000 corporate bonds and fixed income ETFs. Applying proprietary artificial intelligence to pricing, curve visualization, market liquidity, issuance propensity, new issuance spreads, default risk and automated reporting, Overbond enables trade automation and enhances trade performance and portfolio returns. Clients of Toronto-based Overbond include global investment banks, broker dealers, institutional investors, corporations and governments across the Americas, Europe and Asia.