Bond Market Volatility Tests ETFs

July 05, 2013


State Street halted cash redemptions in its municipal bond ETFs two weeks ago, announcing that it would redeem ETF shares for the underlying bonds only.

“The reason ETF issuers switch to in-kind creations and redemptions in volatile markets is that if they offer to create or redeem in cash (plus or minus a spread), they may not be able to achieve those spread levels in the market, placing them at the mercy of other dealing desks,” explained Kssis.

ETF issuers contacted by defended the performance of their funds during the sell-off, in particular the robustness of the underlying structures for creating and redeeming fund units.

“Our fixed-income ETFs performed exactly as we would expect amid the recent market volatility, just as they have in previous volatile markets,” said Leland Clemons, managing director and head of capital markets at iShares in London.

“Both primary and secondary markets continue to function well. While liquidity strains in the underlying bonds may have an effect on brokers’ costs to access the primary market, ETFs’ secondary market liquidity serves as a ‘buffer’ of additional liquidity,” argued Clemons.

“Any liquidity dislocation that occurs in the bond market (for example, in high-yield or emerging market bonds) is going to impact all investors to varying degrees, regardless of the means by which they obtain that exposure. So, despite conditions in the underlying bond market, exchange-level trading may still provide a market clearing mechanism in which investors could transfer risk and ascertain value in the underlying bond portfolio through the ETF structure,” said Clemons.

“ETFs have operated in precisely the way they were designed to do, that is to provide liquidity and price discovery to enable investors of all kinds to express their investment opinion at any point during the trading day,” Paul Young, director in State Street’s ETF capital markets team, told

“The underlying market is operating as you would expect during a volatile period and this is no different whether you are trading through an ETF or using any other open-ended investment vehicle. We have seen a pick-up in ETF primary market activity with the increased volatility, as you would expect, and this has all been dealt with without any changes to our standard processes,” said Young.

Asked to comment on the significance of Citi’s temporary suspension of ETF redemptions, both iShares and State Street stressed that their funds had continued to trade as normal during the episode, and that their ETFs benefit from an “open architecture” of up to 40 authorised participants (APs), all involved in creating and redeeming ETFs.

On this argument, since they have a large variety of potential trading counterparties, ETF investors are safer than those buying a traditional structured product, who depend on the robustness of the issuer and the fairness of its market-making arm to get a decent exit price.

But there are lingering concerns about the fundamental liquidity of corporate bonds, resulting from the substantial withdrawal of the banks from market-making activities since the financial crisis.

“Corporate bond market liquidity has deteriorated,” Paul Reynolds, founder of Bondcube, a start-up trading platform specialising in the sector, told in a phone interview.

“Since 2008 the behaviour of the banks has changed and they don’t provide the same liquidity that they used to. Their inventories of bonds have shrunk dramatically,” said Reynolds.

“The banks are prepared to price small trades, but not larger ones, via electronic platforms such as Bloomberg, MarketAxess and Tradeweb,” he added.

“They fear that if they take on a big position other dealers will skew the market against them, causing them to take a loss. Large trades are still conducted discreetly, over the telephone.”

“Trading in corporate bonds is like trying to cross a river on a small footbridge. The width of the bridge is the number of banks willing to provide quotes. If you want to carry a large load across you may not be able to.”



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