What The Hell Is Going On With The Largest IG Corporate Bond ETF?

Boy, I’ll tell you what: you people are yanking money out of bond funds like there’s no tomorrow.

Broadly speaking, the week through Valentine’s Day saw the first simultaneous exodus from IG, HY, and EM bond funds since the election. Here’s some context for the size of the cumulative outflow:

Boom

Just kind of skipping straight to what people are most concerned about/focused on (because not everyone is “concerned” per se), LQD (the largest IG corporate bond ETF) has witnessed a mass exodus.

 

Last week, it lost some $2 billion, but the real shocker came on Wednesday when it hemorrhaged something like $922 million, the largest outflow in history:

LQD1

That’s a Trump-ish “bigly”, right there.

As a reminder, this thing is huge in the FI ETF world. Here’s some context:

HGFunds

Again, that Wednesday outflow comes after the worst week in history for LQD in terms of fund flows (-5.5% of total assets). Wednesday’s exodus amounted to 2.7% as a share of total assets.

Is this a big deal? Well, I guess that depends on how you look at it. One thing I would note here is that this looks like more of the same dynamic we’ve warned about on countless occasions in these pages – namely that ETFs are where everyone turns for liquidity these days as they dodge the underlying cash market for the less liquid bonds.

Needless to say, that’s less of an issue for IG than it is for HY, but if you look at CDX, the widening there seems to underscore the notion that investors are tapping the more liquid markets (i.e. ETFs and CDX) first before selling the underlying:

CDX

Here’s Wells Fargo’s George Bory weighing in on the flows exodus and everything else said above:

For the first time since December 2016, U.S. IG credit had an outflow. However, it was entirely concentrated in the ETF segment of the market, whereas mutual funds managed to still collect modest inflows; the same was true for Euro IG. We suspect a portion of these flows may reflect investors having shorted the IG ETFs versus CDX after CDX widened far more than cash last week, opening up an arbitrage opportunity, which has since dissipated as IG cash widened but CDX tightened this week.

For their part, BofAML has this to offer on LQD:

The particular ETF in question (LQD) had about $34bn of assets – or 0.5% of the size of the IG market – before suffering a 2.6% outflow, which is a drop in the bucket. This ETF has suffered outflows all year totaling about $4.7bn as bond prices declined (entirely due to higher interest rates as credit spreads are flat on the year), which is normal. However, we estimate that high grade bond funds and ETFs overall (a category that includes LQD) have seen inflows of $47bn this year. Hence the big story is one of very large inflows as opposed to ETF outflows.

The bank’s Hans Mikkelsen also notes that this isn’t exactly a surprise. “This is to be expected given that the three main drivers of inflows to high grade bond funds/ETFs are 1) good total return performance (instead IG corporate bonds have lost 2.74% so far this year), low interest rate vol (Instead the move index has jumped to 70bps from 47bps) and equity outperformance (instead stocks corrected recently),” he writes, in a note dated Thursday.

Whatever the case, corporate debt ETFs are seeing outflows. Some of this depends on how you slice it, but generally speaking, in the week through Wednesday, IG bond funds saw the first outflows in 60 weeks at $2b, while junk bonds witnessed their second highest outflow in history at nearly $11 billion.

It’s foolhardy to try and make doomsday predictions about what this could ultimately mean for the cash market for the underlying bonds (and some people would say it’s just stupid, especially in IG), but at the end of the day, this always comes down to the same common sense conclusion (via Morgan Stanley):

Investors don’t sell their cash bonds in a big way until they are forced to, which happens when the outflows start picking up more sustainably.

Well they’ve “picked up.”  Whether “sustainably” or not remains to be seen.

Still, as the above mentioned Hans Mikkelsen reminds you, “while the importance of ETFs in IG credit is growing, they are still relatively small.”

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