ETFs Can’t Fix Low Bond Market Liquidity

Industry movers worry ETF trading belies weak bond liquidity.

One theme ran through almost every session at the recent Inside Fixed Income conference: The liquidity that underpins corporate bond ETFs is lacking.

While trading in equity markets has modernized—perhaps to a fault, given the criticism on the need for speed and complex algorithms—trading in bond markets has moved backward over the past few years.

As panelists noted at the conference on Oct. 22 in Newport Beach, California, primary dealers of corporate bonds—giant banks—aren’t making robust markets as they have in past times, partly due to regulation in the wake of the 2008 financial crisis. Note in the graph below how dealer inventories have dwindled in recent years.

Meanwhile, corporations have taken advantage of incredibly low interest rates to issue more and more debt.

The net result is a lower proportion of outstanding bonds that are readily available to trade at primary dealers. Some panelists also lamented a drained talent pool at the primary dealers as veteran traders have moved on.

ETF Alchemy

Paradoxically, fixed-income ETFs themselves are trading quite well even if their underlying assets aren’t. Corporate bond ETFs—the popular ones anyway—tend to trade at very tight spreads. This is the alchemy: ETFs are often far cheaper to trade than it would be to trade the basket of the underlying bonds.

So why all the fuss? The worry is that liquidity for bond ETFs will greatly deteriorate in a major downturn given that the underlying markets aren’t strong.

So far that hasn’t happened, but we haven’t seen a true test either.

The Brighter Side

One panelist noted a bright spot compared with the old days of trading entire bond portfolios in panicked markets: At least with an ETF, once it’s sold, you’re completely out, rather than trying to unwind your portfolio over many days. Another panelist recognized flaws in bond liquidity, but didn’t consider that a systemic threat to bond investing.

For now, we know that healthy bond ETFs trade well in good times and reasonably well in moderately bad times. The true test of how trading holds up in a major meltdown remains to be seen.

Contact Paul Britt at [email protected].