The June market sell-off raises questions about the robustness of bond ETFs.
[This article previously appeared on our sister site, IndexUniverse.eu.]
Last month was far from the first time that bond exchange-traded funds (ETFs) have suffered a sharp sell-off. Notable episodes of market volatility occurred in 2008 and 2010, causing some fixed-income trackers, particularly those in less liquid areas of the market, to register large discounts to their net asset value (NAV) in secondary market trading.
This time round, discounts to NAV have been far smaller than the double-digit percentages recorded by some funds in 2008. As we noted in a recent article, the two largest high-yield bond ETFs listed in the US traded with end-of-day discounts of under one percent during the first three weeks of June.
But concerns about the robustness of the fixed-income tracker fund market persist and bond ETF growth means that far greater sums are now at stake compared to previous spells of market turbulence.
In what was at least a temporary reversal of the recent growth trend, June saw record, $12 billion outflows from US ETFs, with bond funds accounting for two-thirds of the redemptions.
And when one market maker, Citi, was reported two weeks ago to have stopped taking sell orders in ETFs in the US more fundamental questions were asked about the reliability of the process by which exchange-traded funds are created and redeemed.
Citi declined to link its decision to stop processing ETF redemptions to investors' sales of bond funds. The bank said it had reached capital limits on its US trading desk, with no particular issuers or funds named. In the Financial Times story that first reported the trading halt one Citi trader is said to have told market counterparts that “we are maxed out on the amount of collateral we have out.”
Questioned by IU.eu on the specific role of collateral in the affected primary market transactions, Citi also declined to comment further.
But one trader, speaking on condition of anonymity, told IndexUniverse.eu that “collateral can be involved in a primary market transaction if the exchange of ETF shares for cash or securities is on a 'free-of-payment’ basis.”
In a free-of-payment primary market redemption a trader sends the ETF shares to the issuer and receives cash or the underlying securities up to two days later. In a free-of-payment creation, the trader sends cash or securities to the ETF issuer and receives the ETF units after an equivalent delay.
By contrast, in a "delivery versus payment" transaction, the ETF shares are exchanged at the ETF’s custodian simultaneously for cash or securities.
“A lot of physically-replicated funds create or redeem shares on a free-of-payment basis,” continued the trader.
Given the time lag between the original creation and redemption order and the ultimate settlement of the transaction, and particularly for larger deal sizes, it’s therefore standard practice for the party that’s awaiting delivery of ETF units or the underlying shares to require the temporary collateralisation of its exposures.
Even though collateralised trades are notionally much safer than those that involve uncollateralised exposures, banks’ risk departments may still set limits for particular counterparties or types of transaction.
Another trader pointed to a possible linkage between Citi's trading halt and the volumes of redemptions in bond funds, noting that the “delta-one” desks at banks, which process the creations and redemptions of ETFs, are typically located within the equity departments of the banks, and so may not have expertise in handling large fixed-income deals, particularly in less liquid areas of the market.
“Delta one desks are predominantly part of the equity divisions at banks and may not be able to source liquidity in bonds very well,” said Laurent Kssis, partner at London-based trading firm Bluefin Europe. “They would prefer to do redemptions for cash and if cash redemptions have been halted, they are dependent on other bond dealers to unwind positions.”
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 IndexUniverse.eu 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 IndexUniverse.eu.
“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 IndexUniverse.eu 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.”
Recognising the potential liquidity constraints involved in trading bonds, and as the fixed-income ETF market has grown in size, issuers have adapted their procedures for creating and redeeming fund units.
Last year we described how the creation and redemption process for any ETF investing in a less liquid area of the market may involve an exchange of “baskets” of securities quite different from the index being tracked, as the ETF’s managers use creations and redemptions as a way of rebalancing the fund’s portfolio.
Such baskets may even be as small as a few bonds each in a fund tracking an index with hundreds of constituents.
Creation and redemption baskets may also vary regularly in make-up, even changing intraday.
iShares explained to IndexUniverse.eu that in certain fixed income funds its creation and redemption baskets are valid only up to a maximum transaction size, after which it reserves the right to “refresh” the basket constituents.
This, said one market maker, makes it harder for dealers to quote tight secondary market prices in the ETFs concerned.
“Because the redemption basket we are given by the ETF issuer may be valid only up to a fixed dollar amount, after which the issuer may change the basket’s components, we face uncertainty quoting for a bond ETF transaction in a larger size,” Bluefin’s Laurent Kssis told IndexUniverse.eu.
“That’s because we don’t know what bonds we’re going to receive and how easy it will be to sell or hedge them. We can’t source liquidity in some of the bonds and as a market maker we therefore run a risk. When markets get volatile these are tricky products to trade.”
There is often an element of negotiation in the primary market interaction between ETF issuer and authorised participant, demonstrating a lack of standardisation in the creation and redemption process.
One ETF trader, speaking on condition of anonymity, told IndexUniverse.eu that “if we get a redemption basket and there are a couple of bonds we don’t like, we can start a negotiation process [with the issuer] and maybe get them to replace them with something else.”
But, in extremis, bond market traders requesting an ETF redemption have to accept the securities they are given by the issuer in return, removing the possibility of negotiation. Both iShares and State Street told IndexUniverse.eu that their portfolio managers have the ultimate say on what goes into creation and redemption baskets.
According to some observers, forcing APs to accept the less liquid “tail” of the bond portfolio in redemptions could accelerate market sell-offs, possibly even leading to a downward price spiral if APs feel forced to use the ETF itself to hedge losing and illiquid bond positions.
iShares stressed to IndexUniverse.eu that, despite the apparent lack of standardised procedures in the bond ETF primary market, a central principle remains.
“In-kind creation/redemption is designed to be a fair process, whereby creation/redemption baskets should be representative of risk characteristics of the fund,” the firm’s Clemons told IndexUniverse.eu.
One trader, who declined to be named, took a phlegmatic view, arguing that recent bond market volatility should serve as a healthy warning to ETF investors.
“From time to time we get a reminder that an ETF is only as liquid as its underlying asset class. This is not rocket science,” he said.