Corporate Bond ETFs Performing Under Pressure

September 20, 2016

(Editor's note: The following is a white paper from Tony Barchetto, executive vice president, head of corporate development, at Bats Global Markets, which owns ETF.com. If your organization has a white paper relating to ETFs that you would like us to consider publishing, please send it to [email protected].)
 
Executive Summary
Investors are increasingly turning to corporate bond exchange-traded funds (ETFs) to gain exposure to credit markets, creating a phenomenon where fixed-income price discovery is occurring within an equity market structure. While some warn that such trading in bond ETFs could compound problems in a genuine liquidity crisis, the findings of this paper suggest that corporate bond ETFs have performed similarly to ETFs in other asset classes. This is demonstrated by bid/ask spreads, trading volume, and quoted size during some periods of significant stress in the credit markets in recent years.

Background

Liquidity in the corporate bond market has been a hot topic for investors, asset managers, dealers and regulators alike. Corporate bonds held in inventory by major dealers since the 2008 financial crisis have declined while bond issuance has continued to rise. Net dealer holdings actually turned negative for the first time ever, according to Federal Reserve data from October 2015,1 while the size of the corporate bond market as measured by issuance has swelled by about $4 trillion since 2009.2 Some observers believe this downturn in dealer inventory could lead to a full-blown liquidity crisis in the event of an upturn in interest rates or other event in the credit markets. 

Some market participants are reporting difficulty in executing corporate bond trades with traditional primary dealers stepping back from their existing role of using their own balance sheets to facilitate client trades. Others downplay the potential for market turmoil, with a report from the Federal Reserve of New York3 showing current bid/ask spreads lower than they were in the pre-crisis years of 2004-2006.

Corporate bond ETFs are an increasingly popular way for investors to get exposure to fixed income, offering access to baskets of corporate bonds that trade on equity platforms like any other stock or ETF. Through mid-July of this year, investors poured over $73 billion into global fixed-income ETFs,4 already approaching the record 2015 haul of $93.5 billion. And about $7 billion in fixed-income ETFs changed hands each day in July 2016, up from a little over $3 billion at the end of 2010, according to Bloomberg.

As with equity-based funds, bond ETFs use a create/redeem process: Market makers called “authorized participants” are granted the ability to exchange shares of the fund for a representative basket of the underlying securities, or vice versa. This system, which is unique to ETFs, allows market participants to gain access to more liquidity than is shown in the ETF quote by sourcing directly from the underlying market. Arbitrage between the ETF shares and the underlying securities throughout the day generally keeps the prices of both in lockstep with each other. 

The same difficulty in trading individual cash bonds that asset managers face spills over to liquidity providers in corporate bond ETFs. In order to create ETF shares, the authorized participants must go into the market to source the underlying bonds to deliver. If these bonds are difficult to obtain, in theory this should affect the liquidity of the ETF—widening spreads due to the risk of trading the bonds. Yet a number of corporate bond ETFs maintain very tight and liquid markets even without significant enhancements in the underlying liquidity. Why?

 

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