Do Bond ETFs Only Provide An Illusion Of Liquidity?

With the benefit of experience gained during the global financial crisis, several key regulators have flagged the liquidity characteristics of some areas of the bond market as a potential risk on the horizon. But are these fears justified when it comes to fixed income ETFs?

Regulators point to the tremendous growth of the fixed income market — up three-fold from the early 2000s to more than $90 trillion today — combined with lower trading volumes and a significant decrease in corporate bond inventories held by U.S. and European banks (75 percent and 50 percent lower, respectively). They also note the low-rate environment has continued to foster a global search for yield, with investors of all types increasing exposure to higher-risk and potentially less-liquid areas of the global capital markets.

These facts have contributed to fears of a disorderly market environment should investors decide to reduce their exposure to certain segments of the bond market (e.g. high yield corporates) en masse. This has been widely covered in the financial press, with some commentators questioning the role ETFs have played – from opening up previously hard-to access areas of the market such as emerging markets bonds, to providing vehicles that offer intraday liquidity on inherently illiquid assets class segments such as high yield bonds and leveraged loans. Despite increased usage, ETFs still represent a comparatively small fraction of assets held in traditional pooled funds.

The Key Elements Of Fixed Income ETFs

There are various sources of liquidity, however. Underlying bond liquidity is the most relevant factor in an ETF. These characteristics change over time and, like other asset classes, depend on the size in which investors wish to transact, the time of day and general market sentiment. While some areas of the fixed income market — US Treasuries for instance – are highly liquid with daily volume in the billions of dollars, other areas of the market are significantly less liquid. The liquidity characteristics of the underlying assets should always be considered by investors before investing in any fund.

Investors in ETFs stand to benefit from the additional liquidity resulting from the exchange-traded nature of ETFs. This allows investors and market makers to buy or sell shares in the ETF on the secondary market without any bonds actually being traded in the portfolio. Comparing the average daily trading volume of an ETF to the change in the number of shares outstanding highlights this dynamic; in some cases, the daily trading volume of an ETF is in the hundreds of millions (or even billions) of dollars and yet ETF flows – either positive or negative – are negligible.

There is another advantage. Depending on the size of the ETF and demand for secondary market trading, the spreads on the ETF may actually be tighter than the spreads on the underlying bonds. This attribute, where applicable, enables ETF investors to effectively access asset classes more cheaply than they could if they were to buy bonds directly.

Be Aware Of The Risks

Some say the liquid characteristics of ETFs can give investors a false sense of security. Investors should recognise that liquidity characteristics change over time and they are still buying a fixed income exposure, with the usual risks attached to it; the equitised nature of the ETF simplifies investing, but it does not change the fundamental characteristics of the securities the ETF holds.

So while at times, and in some ETFs, it may be possible to transact in significant size within the spreads of the underlying bonds, investors should not assume that will always be the case.  ETFs, like the underlying bonds themselves, are subject to the usual vagaries of supply and demand.

Ultimately, ETFs are simply an efficient vehicle for investors to access a range of asset classes. Their benefits should not be overblown — if the market for US high yield bonds becomes illiquid and market values decline 20 percent, one should expect a comparable fall in the value of the ETF.

Characteristics Of Fixed Income ETFs That Aid Liquidity

Most ETFs are passively managed vehicles tracking indices calculated and maintained by reputable external index providers who offer high quality, rigorous methodologies that are rules-based, and who are able to respond to market events quickly and transparently through consultation with market participants.

Furthermore, the presence of several dozen market makers, authorised participants (AP), arbitrageurs and other investors helps maintain an orderly secondary market in ETF shares. All ETFs have an official market maker who is obliged to quote prices continuously throughout the trading day. This is an important point. ETFs may trade while the underlying securities markets are closed or, in the case of some areas of the bond market, are somewhat illiquid.

The creation and redemption of ETF units underpins activity in the secondary market and helps maintain orderly trading of ETF shares. In cases where there is significant selling pressure, APs can initiate redemption orders with the ETF provider, where ETF shares are exchanged for the underlying securities and/or cash.

'Gating' Of ETF Investors

Concerns that fixed income ETF providers would regularly gate (i.e. restrict exit from funds) large numbers of investors during episodes of market 'dislocation' are unfounded. Since the first bond ETF was launched in 2004, the market has experienced dislocations including the global financial crisis, the eurozone debt crisis and 'taper tantrum', when the former Fed chairman said he would wind down quantitative easing, and providers have not gated any investors during these times.

ETFs are highly regulated UCITS funds and face considerable limits in order to gate an investor. While UCITS rules permit fund directors to delay any redemption request from APs that represents over 10 percent of the fund's assets – including where multiple trades equal more than 10 percent in aggregate over the course of the day – in practice this drastic step would likely only be implemented in extreme market conditions at the request of the portfolio management team, where liquidity is severely strained.

Almost all UCITS funds have some form of dilution mechanism, to ensure the costs of entering or exiting the funds are borne by the shareholders doing so, and not by the investors who remain. Investors should make a point of understanding the dilution mechanisms applied by their UCITS vehicle in detail, be it an ETF or another fund structure, when investing in less liquid segments of the market.

Investors do need to be more careful when trading their positions during turbulent markets and should expect potentially higher costs, but the very point of ETFs is that investors can access their money as needed throughout the trading day. This should remain the case going forward.

Alexis Marinof is managing director of State Street Global Advisors and EMEA head of SPDR ETFs