You might recall that one of the consistent themes in these pages revolves around the extent to which HY and EM bond funds are hiding an inherent liquidity mismatch that to this day the vast majority of investors either underestimate or simply don’t understand.
We’re not going to rehash the whole story here (it’s Saturday, after all), but really, the criticism is based on common sense so it can be summarized quite succinctly as follows: you cannot promise intraday liquidity against assets that aren’t liquid.
That is so self-evident that it borders on being tautological.
And indeed that’s why it’s not entirely clear to me why HY and EM debt ETFs are even legal.
The whole charade rests on the patently absurd contention that while inflows equals bond buying, somehow outflows won’t ultimately equal bond selling. Here are just a couple of the innumerable posts we’ve written on this:
- ‘People Are Going To See There’s No Liquidity’: EM ETFs Face ‘Minsky Moment’
- Am I Wrong About ETFs Being “Financial WMDs”? Goldman Says “Probably”
ETF providers and all kinds of ostensibly smart people will provide a laundry list of intelligent-sounding arguments as to why HY and EM bond funds aren’t a liquidity mismatched nightmare, but at the end of the day no one – and I repeat no one – has been able to succinctly and satisfactorily answer the very simple question implicit in Howard Marks’s critique (ca. 2015):
…an ETF cannot be more liquid than the underlying and we all know the underlying can become highly illiquid.
What makes this situation immeasurably worse is the fact (and it is just that – a fact) that fund managers are using these things as liquidity conduits. They’re trading them back and forth with each other to satisfy daily liquidity needs in order to avoid the cash market for the underlying bonds. And the reason they’re doing that is because that cash market is illiquid – we’re talking about HY and EM debt after all.
Worse still, fund managers are using HYG (the popular US HY ETF) as a liquidity sleeve. That is, they’re holding HYG shares instead of cash. The reason they do that is so they can have their cake and eat it too. They get to stay fully invested in junk bonds while claiming that HYG is as good as holding cash against potential outflows. Clearly, that’s fucking nonsense.
Well with that in mind, consider the following from Bloomberg and draw your own conclusions…
Cash balances in emerging-market debt funds are touching lows notched in the aftermath of the 2013 Taper Tantrum, as investors soak up bumper bond supply and extend bullish positions in obligations issued by sovereigns and corporates alike.
Dry powder among emerging-market portfolios is at just 3.4 percent of assets, close to levels posted after the tumult that roiled developing-economy assets four years ago, according to a JPMorgan Chase & Co. client survey conducted last month.
While that makes it harder for fund managers to avoid selling securities if volatility jumps from record lows and redemptions increase, it also underscores bullish expectations that fresh money will keep flowing in over the coming months.
“Cash balances can often move lower in periods of high inflows, where investors see a good pipeline of inflows ahead and markets are performing,” said Jonny Goulden, who heads local emerging-market debt research at JPMorgan in London. “The expected inflows will move portfolios less overweight and will replenish cash balances, so fund managers may be more happy to run lower cash balances in these periods.”
Note those last bolded bits.
That’s a disaster waiting to happen. They’re running down their cash buffers because they expect more inflows.
But if those inflows don’t materialize (like say if there’s a sudden bout of risk-off sentiment that makes market participants sour on EM assets and the carry trade in general) and instead turn into outflows, there will be no cash on hand. And when there’s no cash on hand and the flows are unidirectional, guess what? They have to tap the underlying market for the bonds.