Thanks to the 'Network Effect,' This Bond-Trading Pioneer Will Only Get Stronger

The bond market continues to shift toward electronic trading...

For years, the bond-trading process was long and drawn-out.

First, investors had to fill out paperwork to establish a trading relationship with a few broker-dealers. Then, they had to provide both a buy ("bid") and sell ("ask") price for the bond.

If the broker did not have the bond in its own inventory, the investor waited for the broker to call other clients and find willing sellers or buyers for the other side of the trade.

Then, if the broker could find the bond, it eventually called the investor back with bid prices that built in healthy profits – sometimes as much as 5% of the price of the bond – for the broker.

But that's all changing. And the coronavirus is accelerating the process...

JPMorgan Chase's bond-trading data showed that 77% of Treasury bond trades were conducted electronically in June. That's a quick rise from about 70% in March and well above the average of about 50% over the past two years.

JPMorgan said the data indicate a dramatic shift in the way the entire bond market trades, not just Treasurys. And while we may see a decrease in electronic trading as money managers return to their offices, the electronic-trading trend is here to stay.

Today's company helped pioneer this shift...

We're talking about bond-trading platform MarketAxess (Nasdaq: MKTX).

MarketAxess is a huge player in bond trading. It accounts for more than 80% of all online corporate-bond trades. And it makes up a large part of the entire bond-trading market. In its most recent quarterly report, the company said it makes up 22% of all high-grade bond trades and 14% of all high-yield bond trading (electronic or otherwise).

Every time a bond is traded on its platform, MarketAxess takes a small fee. These fees average 0.02% of the value of the transaction. This may not seem like much, but it adds up quickly.

The key to MarketAxess's business is its "Open Trading" platform.

Open Trading is an "all to all" platform. This means the pool of potential trading partners for an investor comprises all of the industry players. This includes other institutional investors, exchange-traded fund market makers, credit hedge funds, and broker-dealers.

The best part about Open Trading is that it cuts out the middleman completely. Through Open Trading, investors can trade directly with one another with no "wholesaler" required.

This is an incredibly simple concept, but it hadn't been implemented in bond trading until MarketAxess came along.

And the company is making moves to eat up more bond-trading market share...

Last year, MarketAxess announced it was acquiring Treasury bond platform LiquidityEdge in a $150 million deal. This expanded MarketAxess's reach into the high-volume Treasury trading market. And it could pull more customers into its other offerings.

A larger number of customers only makes MarketAxess stronger. The company benefits from the "network effect," which means it gets better as it gets bigger.

That's because the more investors who use MarketAxess, the greater the volume of trades on its platform. And the greater the volume of trades, the more other investors join and improve the business... and the more trading fees it makes.

And MarketAxess continues to pull more investors onto its platform...

In July, MarketAxess reported trading volumes of $204 billion. That's up 16% from the same month a year ago. And $234 billion worth of government bonds were traded on its platform thanks to its LiquidityEdge acquisition.

MarketAxess has a strong business model. And that has helped propel its share price higher, even during the pandemic.

MKTX shares outperformed during the sell-off in February and March, "only" falling about 25%, versus the 34% decline for the S&P 500. And they've soared since bottoming on March 23...

Since bottoming with the broader market, MKTX shares are up more than 75%. That dwarfs the 50% return for the S&P 500 over the same period.

The gains for MarketAxess aren't over...

The bond market continues to shift toward electronic trading. The COVID-19 pandemic is accelerating the shift by forcing many to work from home. And MarketAxess is the unquestioned leader in the space. So bond investors are likely going to turn to the company for their electronic bond-trading needs. That should be a continued tailwind for MarketAxess.

Sometimes investing is simple.