Back in April, we brought you something called “CitiWide Change Bank Is Back: Emerging Markets ETF Edition.”
In that post, we lampooned (for the umpteenth time) the ridiculous notion that you can explain away an absurd underlying business model by citing “volume.”
That argument is popular among those who defend the liquidity mismatch inherent in HY and EM bond ETFs and the best way to illustrate why it’s silly is to refer readers back to a classic 1988 SNL skit about a fictional bank called “CitiWide Change Bank.”
The bank’s business model was simple: you bring them one denomination and they’ll give you any kind of change you want. The punchline comes from one of the bank’s executives who says this:
People ask us all the time: how do you make money doing this? The answer is simple: volume.
Clearly, that’s laughable – and everyone watching SNL in the late 80s understood why.
Well, a whole lot of ETF investors don’t understand how that applies to HY and EM bond funds.
The bottom line is that the ETFs promise daily liquidity but the underlying assets simply aren’t that liquid. And those underlying assets don’t become any more liquid when trading in the ETF picks up. In fact, the opposite is true. The more trading shifts from the cash market for the bonds to the ETFs, the less liquid the bonds become and the greater the liquidity mismatch becomes.
FT took up this issue as it relates to EM bonds in a new piece out Monday.
This liquidity mismatch is a major concern given the sheer amount of money that’s flowed into EM this year. “In the first half of this year, ETFs investing in EM bonds took in $13.5bn, according to EPFR, a fund flow monitor — smashing last year’s record of $11bn,” FT notes.
But think about the backdrop for this. We’ve been over this time and time again. You’ve got DM central banks looking to roll back accommodation (so rising DM rates), you’ve got the situation in the Korean peninsula, you’ve got the political turmoil in Brazil, you’ve got the always dicey situation in Turkey, you’ve got the uncertainty surrounding crude prices, you’ve got China deleveraging, and you’ve got an EM rally that’s stretched to the absolute breaking point.
In short, this is laughably precarious. You can read a bit more on the DM normalization angle here.
So the question then, is what happens when the tide turns after all of this money has flowed into EM bond ETFs? The assumption that investors aren’t going to get completely fucked rests on the patently absurd contention that while money coming in equals bond buying, somehow money going out won’t equal bond selling.
Here’s iShares’ Brett Pybus to try and explain how that can possibly be true:
People say ETFs will be forced sellers [in a falling market] but that’s not the experience. ETFs are far more likely to adjust their holdings in kind, by handing over bonds to authorised participants than by selling bonds for cash.
The idea, as FT goes on to remind you, is that “if the share price of an ETF gets out of kilter with its net asset value such APs will quickly step in to buy its shares or its underlying bonds for arbitrage gains.”
But see that only works when shit isn’t going to hell in a handbasket. More simply (and more crudely): eventually someone will have to stop fucking around with these silly ETF units and sell the goddamn bonds. Here’s FT again:
Critics insist that, just as EM bond ETFs have bought billions of dollars of assets as money has flowed in, they — or their APs — will eventually have to sell them if money flows out.
Right. And the thing is, the APs aren’t going to be willing to inventory these things in a pinch. After all, would you want to take a bunch of illiquid bonds onto your balance sheet in a collapsing market?
“If you knew everything was coming up for sale, would you step in?” Eaton Vance’s Michael Cirami asks. “When the redemption basket gets passed on, the person it gets passed to is going to do some fundamental analysis, which the other guy [who bought the ETF] didn’t care about.”
And see that’s where the whole thing breaks down.
Robert Koenigsberger, chief investment officer of Gramercy, had this to say when FT asked him to weigh in:
There has been a tsunami of money coming into EM debt. [When the tide] goes out, the damage is going to be unprecedented.
It’s hard to predict when people will stop buying tulips. But there is going to be an ‘I told you so’ moment.
“Recent public ETF data, as represented by the four widest tracked EM credit ETFs, show a cumulative outflow of 1.4bn since June 27,” Citi writes, in a note dated Friday.
“YTD, inflows have ignored deteriorating fundamentals in Brazil, South Africa, and commodities, as well as rising geopolitical tensions in Korea and Qatar,” the banks goes on to observe, before adding that “a more hawkish tone from the Fed and ECB may have changed this yield chasing behavior.”
Indeed. Note how Citi cites 1.4 billion in outflows since June 27. Well, do you remember what happened on June 27? That was the day Mario Draghi kicked off a monumental selloff in DM bonds by suggesting that the ECB will “look through transitory weakness in inflation.”
That, according to BofAML’s David Hauner is a “mini Minksy moment.”
As for what’s in store, Hauner warns that once “the big Minsky” moment comes, “people will be sitting on these ETFs and find there’s no liquidity.”