At a major ETF conference recently, there was a focus on the significantly increased interest in fixed income exchange-traded funds (ETFs), which echoed discussions I’ve been having with peers and colleagues recently.
It is a natural evolution, but comes with certain health warnings, particularly as it relates to liquidity.
Compared to large, liquid equity markets such as the S&P 500, fixed income markets are considerably more complex with differing return drivers. This perhaps explains why ETF adoption has been somewhat slower in this area, but as the ETF market matures, there is a natural progression to a broader range of asset classes.
With more investors using fixed income ETFs, liquidity becomes especially important, and different parts of the market can have radically different liquidity profiles, which can appear masked by ETFs.
This is much less of a concern from the already-popular areas such as UK gilts and US Treasuries, which are some of the most liquid markets in the world.
However, liquidity drops off very sharply when you move from core sovereign bonds to corporate bonds, even if you just limit yourself to those with an investment grade rating.
Ironically, poorer liquidity may be contributing to the increased use of ETFs in these markets, as they allow trading with lower frictional costs and potentially easier price discovery compared to trading the underlying bonds.
Most importantly, however, this superficial liquidity should not be confused with liquidity of the underlying assets, and this is where some investors risk coming unstuck.
Not all liquidity is equal, especially in corporate bond markets for example. When there are similar numbers of buyers and sellers, as in ‘typical’ daily markets, prices tend not to move significantly, and, crucially, from an ETF point of view, there tends to be very little net trading needed of the underlying bonds in the ETF itself.
As a result of this two-way trading, the fixed income ETF market may appear highly liquid, with tight spreads; this is superficial, low-friction liquidity. The problem comes when there are large, one-directional movements, such as a sudden flight out of the asset class.
In this case, the ETF would need to sell down the underlying assets to meet redemptions.
At this point, the ETF liquidity will be limited to the liquidity of the underlying bond which would very likely be materially worse than the superficial liquidity of the ETF.
The probable result is not only much higher trading costs, but potentially seriously adverse price movements as the market seeks a clearing price for the ETF, in turn reducing the mark-to-market value of the underlying bonds, even in the absence of direct trading.
In stressed markets, chances are you are not going to like the price on offer.
