I’m a broken record on a whole lot of things and corporate bond market liquidity is certainly one of them.
In “What Happens When You Have To Play That Piano Drunk? Or, The Most Absurd Thing I Heard All Day,” I explained how Vanguard seems to be mistaking the problem for the solution when it comes to corporate bond ETFs.
At the center of that discussion was the idea that fund managers are turning increasingly to ETFs and other portfolio products to manage flows at the expense of liquidity in the markets for the underlying assets.
The problem with that – clearly – is that when you stop using something, it goes into disrepair. It gets rusty. Etc, etc.
To the extent flows are diversifiable, fund managers can essentially trade ETFs around to balance flows without having to actually transact in the underlying bonds. The question is what happens when those flows are unidirectional (i.e. not diversifiable). The notion that whenever ETF shares trade at a discount to their underlying assets, broker-dealers will arb the discrepancy away seems to rely on the idea that said broker-dealers will always be willing to buy the ETF shares and redeem them for the underlying bonds. That seems dubious – at best – in the post crisis regulatory environment. I mean, they may be willing to arb that on normal days, but not in a pinch.
The issue here is basically as follows. If portfolio managers are using something like high yield ETFs to match diversifiable fund flows, it means that liquidity in the market for the underlying bonds decreases commensurate with whatever share of those flows is diversifiable. So when those flows become non-diversifiable and managers have to actually transact in the underlying assets, their propensity to use ETFs to match previously diversifiable flows will come back to bite them in the ass.
Consider all of that as you read the following excerpts from a new Barclays note.
We believe that a substantial portion of the assets reported as passive [in high yield] does not represent true retail passive investing, in contrast to investment grade. Instead, it represents institutional managers using passive vehicles, including ETFs, to manage their inflows and outflows. Managers trade ETFs to fund outflows or invest inflows, and it is likely that at least some of these flows replace trades in the secondary corporate bond market.
We’ve shown that inflows and outflows are not perfectly correlated across funds. On average, 54% of fund flows are “diversifiable,” meaning that portfolio managers can reliably use ETFs instead of trading bonds to satisfy a significant share of their own fund flows. Indeed, an analysis of the magnitude of fund flows at the fund level suggests that approximately 25% of the outstanding float in high yield ETFs could be held by portfolio managers with daily liquidity needs.
Several pieces of evidence support this view (alongside anecdotal evidence from money managers and ETF traders). The first is the high concentration of assets among passive high yield funds. The top three passive funds represent 68% of passive high yield assets, while the top three passive government and equity funds represent 39% and 16% of passive assets, respectively. All of the large passive funds in high yield are ETFs, which have the benefit of trading in the secondary market. High concentration leads to larger secondary flows, which is useful for institutional managers trying to use ETFs to manage inflows and outflows. Without sufficient secondary trading, selling of shares is more likely to lead to share destruction, which relies on the liquidity of the underlying market. ETFs mitigate liquidity needs only to the extent that their secondary trading volumes are large relative to primary volumes (ie, share creation and redemption volumes). A large number of thinly traded ETFs would not be useful to institutional managers. Indeed, the largest four high yield ETFs have secondary volumes of 4-8x primary volumes.
In addition to reinforcing everything I said at the outset and everything I’ve been saying for years (well before Heisenberg was Heisenberg), what the passages above suggest is that retail investors aren’t seeing what they think they’re seeing when they look at HY ETFs. That is, investors think they’re looking purely at a vehicle that’s being used for investment purposes but in fact, they’re looking at a product that is at least partially employed by portfolio managers as a tool to avoid trading the underlying bonds.
Barclays isn’t quite as prone to hyperbole as Heisenberg, but I still maintain that this is a disaster waiting to happen.