Fixed-income exchange-traded funds are often criticized for bestowing unearned liquidity and price upon their underlying holdings, particularly in investment-grade and high-yield corporate debt. But with U.S.-listed corporate debt ETFs seeing $100 billion of inflows in the past five years, the near constant pricing and transparency in the ETF ecosystem is overtly affecting the corporate debt market.
"Transparency in bond pricing has gone up significantly," said Kurt Halvorson, a fixed-income portfolio manager at Western Asset Management Co. LLC, in Pasadena, Calif. "However, we have also seen liquidity become more bifurcated, with index-eligible bonds reaching much higher volumes. Issuers are aware of this trend and I think we will see them become even more cognizant over time."
The intraday pricing of bond portfolios — primarily in the form of index ETFs — provides reference prices for index-eligible corporate debt of all sizes and maturities. For issuers of debt securities, evidence is emerging that index-eligibility and ETF inclusion affect the pricing and liquidity of bond issues, bringing with them demand from not only ETFs, but also broader passive mandates, including mutual funds and separately managed accounts, as well as pension funds and insurance firms.
While the largest products in the $215 billion corporate debt ETF market trade anwhere from 100,000 to 20 million shares per day on average, according to LSEG Information Services (U.S.) Inc. But only about 3.4% of daily trading activity results in a primary market trade through the creation or redemption of ETF shares, according to a working paper "Fixed Income ETFs and Bond Liquidity," by Thomas Marta, a former market-maker at Bluefin Trading LLC in London and currently a doctoral candidate at Paris University Dauphine. These creation and redemption trades move a basket of bonds into or out of the ETF itself and are usually paired with the acquisition or disposition of those securities by a market maker.
"Bond ETFs have become a leading price indicator," said Matt Berger, global head of fixed income, currencies and commodities for Jane Street Capital LLC in New York. "When providing our corporate bond liquidity, it could come in the form of ETFs or bonds. We don't view them as two separate markets."
For example, the rise of ETFs has accelerated the trend of portfolio trading in corporate securities outside of ETF activity. Originally handled by the largest dealers on Wall Street, electronic platforms are closing that gap.
"The technology, processes, and workflow developed to make ETF creations and redemptions easier was coincident with technology and pricing upgrades and the arrival of algorithmic market making in the underlying securities," said Chris Bruner, head of U.S. credit for Tradeweb in New York. According to Mr. Bruner, Tradeweb clients have made more than $18 billion in trades as small as $5 million and as large as $1 billion since the company launched corporate bond portfolio trading earlier this year, essentially using the same process that an ETF market-maker would use to price and trade a basket of securities.
Tradeweb competitor MarketAxess announced in June that it was set to launch its own portfolio trading platform this fall.
Long-term U.S. corporate debt outstanding at the end of 2018 was $9.2 trillion, according to Federal Reserve data from SIFMA. Average daily trading volume in U.S. investment-grade corporate debt was $20.6 billion through July, up 14.1% compared to last year, while trading of investment grade 144A bonds was $3.1 billion, up 21.2%, according to FINRA TRACE data and analysis from SIFMA.
Yet, an analysis of multiple sources by the International Monetary Fund in the April 2019 Global Financial Stability Report found U.S. investment-grade corporate-bond trading market to be the least electronic (estimated between 15% to 20%) among major global financial asset markets.
"The dealer community used to be focused on providing balance sheet, which gave a buffer to the credit market in times of volatility, but over the past few years they have transitioned more to accommodate the ETF infrastructure which includes both portfolio trading as well as creations and redemptions," said Western Asset's Mr. Halvorson. "This will lead to more bifurcation and greater price disparity when the market focus is less about individual credits and more about overall flows."
Recent academic papers have argued that inclusion in an ETF enhances the pricing of an index-eligible bond, though the literature is mixed on the impact of liquidity. While ETF inclusion and index-eligibility should increase the potential buyers for an existing issuance (in aggregate), the transparency of ETF pricing and TRACE reporting has compromised dealer's "ability to make their margin on less liquid issues," said Mr. Halvorson.