Another day another warning about emerging market debt ETFs.
This has become something of a crusade for us in the weeks that followed Mario Draghi’s efforts to marshal global support for a hawkish shift from DM central banks.
That effort kicked off on June 27 in Sintra, Portugal, and it was followed by a rates mini-tantrum that contributed to outflows from EM bond funds, most notably the iShares JPMorgan EM Bond ETF. Have a look:
We’re not going to rehash the whole story here, but for those interested in the details on why this situation is precarious, you can check out these posts:
- ‘These Are The Most Illiquid Conditions I Have Ever Seen’: One CIO Warns On EM ETFs
- Danger, Will Robinson! Emerging Market Bond Funds See Slowest Inflows In 23 Weeks
- ‘People Are Going To See There’s No Liquidity’: EM ETFs Face ‘Minsky Moment’
In a nutshell, the question is the same as it is for HY ETFs. Namely, what happens when outflows collide head-on with vehicles that promise intraday liquidity against illiquid assets?
The assumption is that this apparent contradiction (i.e. liquidity in the ETF units but not in the assets they represent) will somehow resolve itself through the magic of the creation/destruction process and the arb opportunity for APs.
That, we think, is a dubious proposition.
Well anyway, for those interested in a a granular breakdown of the EM ETF market, consider the following out from BofAML on Monday – it might come in handy down the road.
Do note the breakdown of what these vehicles own in terms of sovereigns versus corporates, as the higher ownership of sovereigns was what recently led to an anomaly in the market that saw sovereigns trading wide to corporates:
Oh, and this bit is key, as it underscores the liquidity argument outlined above and delineated in our previous posts:
ETFs are likely to be disproportionally influential during market selloffs given their limited cash levels to absorb outflows and a more opportunistic investor base.
ETFs have grown rapidly; EM corporate holdings still small
The move higher in DM core rates earlier in the month sparked outflows from EM hard currency (EXD) exchange traded funds (ETFs) for 2 consecutive weeks. While EM EXD ETFs have almost tripled in size since February 2016 to $30 bn (Chart 2), they still only account for 1.4% of the combined EM corporate and sovereign external debt outstanding. Mutual funds have also grown and now account for 8% of the EM EXD market. We estimate that EXD ETFs hold a much larger share of sovereign bonds ($25 bn) compared to corporate bonds ($5.8 bn). This should insulate corporates, at least initially, from pricing volatility driven by ETF flows. Eventually corporate valuations would most likely move in line with sovereign valuations, particularly for quasis. On an issuer basis, ETFs hold anywhere from 0.2% to 5% of any given corporate issuer’s total outstanding vs. 2%-7% for sovereign bonds.
Risk is back on in EM credit in July
EM credit’s performance MTD has largely driven by the moves in DM rates which have been volatile. EM corporate yields had risen 6 bps to 4.35% (the highest level since March) earlier in the month before falling 9 bps to 4.26%. Corporate spreads vs. UST are 2 bps tighter MTD at 259 bps, with HY spreads outperforming IG. LatAm is outperforming Asia and EEMEA in both rating categories.
EXD ETFs have grown rapidly but remain smaller than MFs. ETFs that invest in EM hard currency bonds have grown dramatically over the last year and a half, with total assets rising from $13 bn in February 2016 to $31 bn today. But as a share of index-eligible EM corporate and sovereign bonds, ETFs hold only 1.4%. EM EXD mutual funds’ AUM (as reported by EPFR) are 6x larger than ETFs (Chart 4). But as David Hauner wrote last month, ETFs are likely to be disproportionally influential during market selloffs given their limited cash levels to absorb outflows and a more opportunistic investor base. Indeed, the move higher in DM core rates earlier in July sparked large outflows from the largest hard currency ETFs.
ETFs hold highest share of corporates in smaller countries. To gauge the importance of ETFs to EM corporates, we reviewed the portfolio allocations of 33 hard currency and blended ETFs as tracked by EPFR. We estimate that these ETFs only hold $5.8 bn of EM corporate bonds, compared to much larger holdings of government bonds (Chart 5). We also reviewed the individual holdings of the 15 largest EM EXD ETFs which have an allocation to EM corporates. ETFs hold the largest nominal amount of corporate bonds in China ($1.1 bn) and Mexico ($0.8 bn), with the largest holdings being Pemex ($0.7 bn) and SINOPE ($0.4 bn). Other large holding of ETFs are Petronas ($0.4 bn) and Codelco ($0.3 bn). ETFs hold only $0.1 bn of Petrobras. The main reason is that the three largest EXD ETFs only hold 100% state-owned corporates. We also note that ETFs hold a relatively high share of smaller 100% quasis such as PLNIJ, ESKOM, KZOKZ, SGCAZE and SAFTRA.