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Bond ETFs: Here comes trouble

7 Oct 2019

Bond ETFs have become a popular vehicle for adding liquidity to an institutional portfolio, but will they stand the test of a more volatile market environment? Mona Dohle investigates.

Exchange-traded funds (ETFs) and pension funds are strange bedfellows. As institutional investors, pension schemes are in the fortunate position of being able to commit to large scale, relatively illiquid investments to achieve higher returns. Yet with the exponential growth of the ETF market during the past decade, institutional investor demand has increased strongly.

The drivers of institutional investors’ appetite for passives have been widely covered, they offer an alternative to poorly performing active funds and lower costs. Yet the main reason why pension schemes choose to go passive appears to be liquidity. Some 80% of institutional investors hold ETFs due to how quickly they can be turned into cash, according to a survey by Greenwich Associates. Almost half of all respondents also indicated that they are using bond ETFs as a cash proxy, but can such vehicles offer additional liquidity when volatility spikes?

BOND MARKET DRAUGHT

Times are undoubtedly challenging for bond market investors. After more than a decade of loose monetary policy, a quarter of the world’s bonds, amounting to more than $14trn (£11.48trn), are now trading at negative rates. Over the summer, the US yield curve slipped into inversion with the yield on 10-year US treasuries falling below that of two-year bonds as investors piled into long-term high-grade debt for safety.

Yet for many institutional investors, defined benefit (DB) schemes in particular, holding illiquid assets alone is simply not an option. The majority of final salary schemes in the UK are closed to further accrual and as the share of pension recipients is rising, so has the need to keep assets which can be readily converted into cash.

That is easier said than done. Some 78% of institutional investors report that it has become harder to trade bonds on primary markets, according to Greenwich Associates. One reason is the heightened capital reserve requirement that was introduced in the aftermath of the financial crisis. They have made it more expensive for banks to operate as market makers.

In this context, bond ETFs have become a popular choice. As of July, assets invested in European ETFs and exchange-traded products (ETPs) reached a record $910.3bn (£748.9bn), while US ETFs hit the $4trn (£3.29trn) milestone, according to data specialist ETFGI. In the UK alone, assets invested in UK-listed ETFs spiked to £250bn in 2018, up from £11bn 10 years earlier, the Investment Association says. The industry body also claims that institutional investors have jumped in on the hype with about a third of pension fund assets being invested passively.

Some of the arguments for investing in ETFs sound a lot like the reasons for investing in collateralised debt obligations before the last recession.

Stuart Trow, European Bank for Reconstruction and Development

The appeal of passives lies in their unique structure as a hybrid between open and closed-ended funds and being traded as shares. However, this feature could also be the root concern around liquidity.

The benefits of investing in bond ETFs are clear. Being traded daily, fund providers disclose their holdings at the end of each day, offering increased transparency.

Moreover, because ETFs are traded as shares, supply is much more flexible than the availability of the underlying assets, making it possible for large institutional investors to execute large scale orders without a significant impact on the price of the ETF.

Frank Mohr, head of ETF sales trading at Commerzbank, says that despite engaging with institutional investors on a regular basis, the process of creating and redeeming ETF shares remains obscure, even to seasoned investors. “One of my slides explains the basic creation and redemption mechanism and even after having given this presentation for eight years I still feel that it is necessary.

“As authorised participants we are entering contracts with the asset management firm, which authorises us to issue and redeem ETF shares which are then sold to the end investors in the secondary market,” Mohr adds. “When we sell ETF shares, we simultaneously go long in the underlying, say high yield emerging market debt to balance our trading books. I then go back to the asset manager which delivers the underlying securities which delivers the underlying securities. There are no maximum capacities for ETF share creation other than the maximum capacity of the underlying in the primary market.”

But the main appeal for institutional investors is of course the fact that by virtue of being traded on the secondary market, it becomes much easier to sell an ETF. Investors buy and sell ETF shares through market makers and authorised participants (AP), rather than from the asset management company which issued them. While APs and market makers have no obligation to buy shares, other market makers might step in because they identified an arbitrage opportunity.

This buffer function of ETFs also extends to primary markets. “In the event of a crash,” Mohr says,” the ETF could have a certain absorber function in the sense that the end investor might be selling the ETF but the underlying bonds will still be traded on primary markets and other authorised participants might be stepping in because spreads are widening again.”

Yet it could be questioned whether these benefits also uphold in the event of a bond market crash, or as Warren Buffet once famously put it: “Only when the tide goes out do you discover who’s been swimming naked.” Investors have been buying ETFs on the premise that the funds are more liquid than their underlying. But financial market regulators have expressed concern about the inherent “liquidity mismatch” which describes the gap between investors belief of how easily they can turn their assets into cash and the ease in reality.

Stuart Trow, credit strategist at the European Bank for Reconstruction and Development, says that institutional investors have been using ETFs as a cash proxy because they feel they can trade them at decent volumes. “But just by making the vehicle liquid doesn’t mean that the underlying is liquid. Some of the arguments for investing in ETFs sound a lot like the reasons for investing in collateralised debt obligations before the last recession,” he adds.

“The problem with institutional investors treating such vehicles as readily realisable assets is that it is replicating some of the problems that they have on the less liquid side of their portfolio rather than solving them. In the event of a crisis, ETFs might still be the first assets to be sold but investors might have to accept selling them at a significant discount to their net asset value,” Trow warns.

Despite being a fervent advocate of the ETF industry, Mohr acknowledges its shortcomings. “The client has to be aware of what they are getting themselves into. Of course, if they invest in an emerging market debt ETF, or junk bonds as we would have called them back in the day, treating them as a cash equivalent would not be prudent.

“There are limitations to that absorber function,” he adds. “ETFs are by no means a panacea. If the world is really coming to an end and everybody wants to sell, the end investor might not find a buyer. It is only a vehicle to facilitate trading in a more effective manner.”

Of course, if they invest in an emerging market debt ETF, or junk bonds as we would have called them back in the day, treating them as a cash equivalent would not be prudent.

Frank Mohr, Commerzbank

Moreover, despite accounting for only a relatively small share of the overall bond market, research suggests that ETFs are associated with increased co-movement and price volatility of asset prices. Investors hold exposure to an asset by virtue of it being included in an index, rather than analysing its liquidity. “An increase in the co-movement of asset prices may pose systemic stability issues, as it makes it more likely that many investors face losses simultaneously, therefore potentially leading to waves of insolvencies and synchronised sales,” the European Systemic Risk Board warns.

REGULATORY BLACK HOLES

Potential supply and demand problems on secondary markets tie in closely to the role of APs and market makers as providers of market liquidity. For an industry which prides itself for its transparency, very little information is being disclosed about these key actors.

While APs receive their authorisation status from the asset management firm issuing the ETF, which usually discloses a list of all its APs, there has so far not been any publically available centralised information on the total number of authorised participants operating in the ETF market. Regulatory oversight is further complicated by the fact that due to the decentralised nature of European stock markets, about 70% of
European ETFs are traded over the counter, rather than on exchange.

A recent research report commissioned by the Financial Conduct Authority (FCA) suggests that the market for APs issuing shares in bond ETFs is concentrated. Indeed, one AP alone accounts for more than half of the markets’ trading volume and the top five cover more than 90% of bond ETF trading volumes. However, the FCA has chosen not to disclose the names of the APs in question, arguing that the information is confidential. For investors in ETFs this should raise the question whether a market can ever be efficiently regulated if the names of key market participants are not even public knowledge.

The European Systemic Risk Board highlights areas of potential conflicts of interest. For example, APs might be part of the same group which has issued the ETF and they could also be the liquidity provider trading ETF shares in the secondary market. This could result in them being reluctant to conduct arbitrage trades that bring the price in line with underlying securities.

For the time being, the issuer side of the ETF market is regulated through Ucits and, to some degree, Mifid or EMIR, yet there is no direct regulation which overlooks APs. Mohr suggests that this might be in part due to the market’s need for flexibility.

Indeed, FCA research shows that in previous episodes of market stress, a spike in bond ETF redemptions was swiftly followed by the emergence of APs, principal trading firms in particular, which absorbed a higher proportion of the redemption volume.

Unlike banks, which have traditionally acted as market makers and APs, principal trading firms tend to have small balance sheets and trade large quantities of securities with zero net exposure by hedging the relevant assets.

For Trow, this remains an area of concern. “With banks no longer incentivised to act as market makers, all these people are essentially relying on proprietary traders, the risk of them all wanting to do the same thing is quite high,” Trow says. “Bonds have been on a real tear today, but nobody is going to want to hold opposing positions.

“Proprietary traders have less interest in market developments and more interest in making money at the moment. That suits everybody when we have a strong market but it will not always be like that,” he adds. Liquidity mismatches, conflicts of interest and lack of regulatory oversight; the list of potential pitfalls for ETF investors is long. Could any of these factors become potentially fatal for ETF investors? Trow is cautious. “It is difficult to say what would knock ETFs over but the fact that in our half an hour conversation we have come up with at least half a dozen of scenarios of how they could be knocked over should be a warning sign. It does not mean that you should not hold ETFs for less liquid securities, but you should treat them as a risk asset,” he warns.

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