Illustration: David Mannion
First published March 11, updated March 20
March 6 was the worst day in the US credit market for more than 10 years. For those who were there when Lehman Brothers failed, the scale of the panic had a sickeningly familiar feel to it, only this time it was being led by airlines and cruise operators rather than banks and other mortgage providers.
Recent events also bear comparison with 2015, when oil-price volatility hit the high-yield credit market, and the disruption in the fourth quarter of 2018. By then things were different, however, thanks to the emergence of bond exchange-traded funds (ETFs) and the early signalling that these funds often provided on broader market behaviour.
This has also held true in the lead up to the latest sell off.
Time and time again when you have market volatility, ETFs have proved themselves- Brett Olson, BlackRock
During the first week of March, investors pulled $6.8 billion from mutual funds and high-yield ETFs, including $4 billion from BlackRock’s flagship HYG ETF, which fell 3.7 points on Monday March 9 alone. Retail investors pulled $1 billion from the high-yield market on March 6, driven by ETFs.
Bank of America analysts observed on March 10: “While HYG was at the epicentre of the ETF redemptions during the last week of February, outflows are now spreading to open-ended funds as well.”
The early growth of ETFs brought with it concerns about how these funds, which offer daily liquidity on portfolios of assets that can be highly illiquid, might exacerbate a market correction. It all looked very reminiscent of the havoc that asset-backed securities conduits and structured investment vehicles wrought as the sub-prime mortgage market started to unravel spectacularly in 2007 and 2008.
Not everyone was convinced about the benign, or positive, market impact of ETFs in extraordinary circumstances. The current bout of volatility should provide a definitive answer.
Jim Reid, head of global fundamental credit strategy at Deutsche Bank, observes that high yield ETFs were hit by the market circuit breaker that was imposed on March 9.
He says: “Given that credit ETFs have been defended by some as liquidity enhancers and not destroyers then this would have shocked a few.”
And there were certainly shocks to come as the gap between ETF closing prices and net asset values (NAVs) widened in the intensifying panic of late March.
At Vanguard’s $55 billion total bond market ETF this discount, which should be tiny, grew to 6.2% on March 12. The firm nevertheless insisted that there was no cause for alarm.
Rich Powers, head of ETF product management at Vanguard, says: “Market prices for ETFs can move more rapidly than the net asset value. That is part of the price discovery process.”
A report published by Societe Generale’s global quantitative, index and ETF team on March 16 pointed out that: “ETF liquidity is not infinite, and its cost and quantity are impacted by severe market conditions, like for any other security.”
The team insists that a mismatch in liquidity between the ETF and the underlying bonds is to be expected, particularly in a relatively illiquid asset class.
“The underlying securities are not very liquid in nature,” it says. “But the related ETFs can be liquid under normal market conditions and when the ETF secondary market is balanced between buyers and sellers. In that case, it is possible to trade relatively sizeable shares of this ETF on the order book or, more likely, off-exchange through a market maker.
“Because the requested ETF shares already exist and do not need to be manufactured, the liquidity cost of the ETF transaction is much lower than that of the underlying bonds. The liquidity advantage of ETF is not imaginary here and is measurable as a difference between the spread of the underlying bonds (say 90 basis points) and the spread of the ETF (10bp) for instance.”
ETF advocates insist that these funds will prove their worth in the current turmoil.
Brett Olson, head of iShares fixed income, EMEA at BlackRock in London tells Euromoney: “Time and time again, when you have market volatility, ETFs have proved themselves. They are price-discovery tools. Over the past six to 12 months, people have looked at fixed income ETFs to see where the market is – they use the ETF instead of having cash drag.”
After enduring that battering on March 9, the sector appeared reasonably resilient, but then saw widening NAV gaps as the crisis intensified.
Keshava Shastry, head of capital markets at DWS Group, insisted on March 10: “As expected during a sustained sell off and sudden significant market volatility, we’ve seen spreads in the ETF market widen, reflecting the underlying securities, but the ETF market has functioned as expected, providing liquid two-way trading for investors.
“We continue to hear from investors and market makers that ETFs are an efficient price-discovery tool and are relatively easy to access, even in these times.”
There is no doubt that bond market liquidity is entirely different today to what it was 10 years ago. It is no longer the preserve of dealer inventories, but is often provided by the buy side itself.
Dealers no longer hold bonds as inventory before selling them, but match buyers and sellers immediately in agency-based trades: while the US investment-grade market has grown by 43% since the crisis, dealer inventories have shrunk to 6% of their former size.
ETFs have played a fundamental role in this.
Originally seen as a quick way for asset managers to get exposure to names that they could not get in the cash market, these funds are now at the forefront of the entire liquidity dynamic across the market. That is not least because of their size.
Of the $271 billion that was put into the US ETF market in 2019, 51% went to fixed-income funds and more than $1 trillion is now invested in bond ETFs (albeit a fraction of the $4.5 trillion in equity ETFs).
Authorized participants create and redeem shares in an ETF by submitting a basket of underlying securities to the ETF issuer, which issues a basket of ETF shares in return. This has driven demand for the trading of large portfolios of bonds and the development of the technology to do this.
If you buy illiquid bonds as part of a portfolio now, you can put them into an ETF. This is a positive for a very illiquid market – it is really improving bond market liquidity during volatile times. ETFs are our friends- Hans Mikkelsen, Bank of America
“ETFs have helped to drive bond-market modernization,” Olson at BlackRock explains. “As the creation and redemption process for ETFs has shifted from cash to in-kind create and redeem, all market participants had to get better at basket trades.”
In-kind redemption – whereby the shares to be redeemed are exchanged for a basket of securities held by the ETF – is the primary mechanism through which ETF create and redeems now take place.
“As banks developed the ability to do basket trades, they then thought about how else they could use this technology,” says Olson.
The answer was portfolio trading, and firms such as Goldman Sachs, Bank of America, Citi and electronic broker Jane Street were quick to take advantage, with more than $88 billion worth of such trades being completed in 2019, according to Morgan Stanley.
Earlier this year, Bank of America told Bloomberg that it is asked to price up to 11 US corporate bond portfolio trades a day, the majority of which are between $100 million and $200 million in size but can be as large as several billion dollars.
Matt King, global head of credit products strategy at Citi, summed up the development in a research paper last November.
“For the vast majority of corporate bonds, it is far from obvious that at any one time there exists a willing buyer and a willing seller, even before we get to any discussion about whether there is a common price at which both would be prepared to transact,” he observed. “Any bond can now find a reasonable bid, provided that it can be presented as part of a broad portfolio which replicates an ETF.”
He called this the ‘Tetris’ effect.
“The subsequent ETF creation trade effectively zaps the entire portfolio from the dealer’s balance sheet.”
The key development here is the technology.
Shastry at DWS points out: “It is not as if portfolio trading didn’t exist before – index managers have existed for many decades – it is just that it has become more significant. Trading platforms and brokers have been investing for automation, which is enabling this.”
The symbiotic relationship between ETFs and portfolio trading is now creating a virtuous circle, whereby the one begets the other. The impact on the bond-trading environment is profound and fast moving.
“ETFs are key for portfolio trading,” says Hans Mikkelsen, head of high-grade credit strategy at Bank of America. “If you buy illiquid bonds as part of a portfolio now, you can put them into an ETF. This is a positive for a very illiquid market – it is really improving bond-market liquidity during volatile times. ETFs are our friends.”
The proof of that pudding will only come when the definitive analysis of the current coronavirus-driven bond market rout is written. In a June 21 report last year, the International Organization of Securities Commissions (Iosco) stated that it believed that asset managers are aware of potential liquidity problems [in the corporate bond market] and “believe they have liquidity risk management arrangements that should allow them to handle an increase in redemption requests from their clients, without having to conduct ‘fire sales’ of their corporate bond assets.”
Let’s hope they are right.
Andrew Jamieson, global head of exchange-traded products at Citi, says: “Over the last couple of weeks where we have witnessed a significant correction and market sell-off, due to ongoing concerns and uncertainty surrounding the coronavirus, ETFs have yet again stood up to the test and largely worked as expected.
“Higher than usual trading volumes are a reflection of the use of ETFs as a ‘cash equitization’ tool, and the ability to sell quickly is a positive outcome and indicative of hedging techniques deployed in fast moving markets.
“Discounts to NAV, often criticized as a shortcoming of these products, while witnessed within fixed income markets, are really an expression of fair value and due to the fact ETFs are price discovery tools,” Jamieson continues. “In real terms, these temporary NAV dislocations are a reflection on the still opaque and illiquid underlying marketplace for individual bonds.
“The only area of possible concern going forward is whether there are sufficient fixed-income specialists within the ETF dealer community for increasing volumes with the ability to seamlessly interact in both the primary and secondary marketplace. Traditionally the historic equity-focused delta-one desks are often constrained by on-screen and secondary activity only. At Citi, our decision to break out ETF trading by asset class has had a real positive impact in times of market stress, as they are traded alongside all the various other instruments in the asset class toolkit.”
It could be tough if the rout persists, however. Analysts Arup Ghosh and Aritra Banerjee at Citi pointed out in mid March that the years-long extraordinary liquidity environment that the credit market has enjoyed has left all credit investors positioned exactly the same way, with dealers having insufficient capacity to smooth out the risk flows, which so far have been heavily concentrated in index hedges.Ghosh and Banerjee warn: “If the sell-off turns out to be one of those career-defining events that happen about once every five years, portfolio managers start selling down bonds from their portfolios usually accompanied by them liquidating the hedges alongside. This is when the pain gets real.”