Poking holes in the bond ETF meltdown scenario

A school of thought has emerged that places fixed-income exchange-traded funds at the center of a potential liquidity crisis in corporate bonds.

If sentiment soured on U.S. investment-grade and high-yield credits, then the marginal investors who gain their exposure to these assets via ETFs would be the first, and fastest, to sell, bringing about a cascade of falling prices for traded and non-traded securities alike.

Such a scenario was explored in recent papers by the Bank for International Settlements, the International Monetary Fund and the widely read quarterly memo from Howard Marks, co-chairman of Oaktree Capital Management.

While there's no denying the decrease in liquidity for corporate bonds, the dynamism of the ETF structure might afford the market more of a buffer rather than serve as a catalyst for cataclysm.

Market-making activity and principal trading desks at broker-dealers have shrunk since the financial crisis, largely because of a lower risk profile and higher capital requirements. Dealer inventories have hovered around $60 billion for several years, down nearly two-thirds from 2008 levels.

Meanwhile, the fixed-income ETF ecosystem of market-makers and arbitrageurs has stepped into the void. Their ability to affect prices, however, might be far smaller and more nuanced than many market observers would like to believe.

Global corporate bond ETFs held $161 billion in assets through March, and saw $19 billion in net flows, according to BlackRock Inc. In the U.S., ETFs focused specifically on corporate debt, including leveraged loans, held $99 billion in assets as of April 23, according to XTF INC. That's only a small part of the overall corporate market, which stood at $7.8 trillion at the end of 2014, according to the Securities Industry and Financial Markets Association. Broader index ETFs, accounting for $117 billion in assets, also have significant U.S. corporate holdings in their portfolios.

In a recent research report, Anthony Perrotta Jr., head of fixed-income research at TABB Group, New York, says the ratio of dollars traded in the ETF vs. dollar flow into or out of the fund indicates a fund's ability to satisfy greater trading activity without causing creations or redemptions, which would directly impact underlying prices.

Mr. Perrotta found that the primary turnover ratio for the $17.7 billion iShares iBoxx USD High Yield Corporate Bond ETF and $22.6 billion iShares iBoxx USD High Grade Corporate Bond ETF — the two largest U.S.-listed corporate bond ETFs — averaged 7-to-1 by the end of 2014.

“Once the ETF reaches a threshold outstanding notional (value), the secondary market is able to support its own trading activity without reliance on the creation/redemption cycle and the need to involve the underlying basket,” wrote Mr. Perrotta. “In essence, the ETF serves as an additional liquidity layer for the underlying market.”

But there's an added nuance to the ETFs that plays to the liquidity dynamics of the corporate bond market. Unlike equity ETFs, where creation/redemption baskets tend to fully replicate the underlying holdings, bond ETF baskets are built to smooth liquidity, either with round lots of liquid securities or customized baskets within the bounds of the ETF's investment goals and risk metrics.

An ETF holding 1,000 CUSIPs might only create and redeem using 60 or 70 specific issues. In this light, ETFs overall are no more or less susceptible to the whims of the market than other holders of less liquid securities, including traditional mutual funds and institutional investors.

The intraday ETF market price, however, can serve as a feedback loop for trading individual securities in an index to the extent that markets lock up and investors are searching for a clearing price.

“Underlying bonds inside ETFs tend to trade tighter” than those not eligible for an index, says Reginald M. Browne, senior managing director at Cantor Fitzgerald LP in New York. Mr. Browne and other ETF market-makers must make daily assessments of both the ETF basket as well as the fully disclosed underlying holdings to the extent that some of those securities may appear in future baskets.

Additionally, those looking to transact in individual issues held by the ETF can also find where the asset manager is marking those securities through their daily holdings disclosure and NAV. “For institutions, this can be another input in their pricing for plain-vanilla corporates,” said Pierre Robert, founder and CEO of Best Credit Data Inc. in Concord, Mass.

TABB's Mr. Perrotta in an interview said the “real downside risk scenario is not so much how the ETF prices, but what exactly is the imbalance between asset owners looking to transact and liquidity providers willing to make a market.” Generally, the cost of liquidity in the underlying holdings, individually and in aggregate, provides the upper and lower bound for ETF trading spreads. “The cash market will ultimately be the guardrail for the ETF price,” said David Krein, head of research for MarketAxess Holdings Inc. in New York.

When those “arbitrage bands” are reached, market-makers and authorized participants would generally create or redeem shares and buy or sell the underlying securities to capture the arbitrage and collapse the spread. In choppier markets for the underlying securities trading spreads can widen out for the ETF itself and the market price may sustain greater premiums or discounts to the NAV.