BIS: Passive Bond Funds May Pose Threat To Financial Stability

Listen, there is absolutely no downside whatsoever to the epochal active-to-passive shift, ok?

Everyone knows that the best way to encourage price discovery and to generally ensure that markets are performing their traditional function as a conduit for the efficient allocation of capital is to open up every corner of every market to unsophisticated retail investors by way of securities with intraday liquidity. It’s even better if you make those same securities tradable by those same retail investors 24-7.

The benefits of this setup are obvious. On the equities side of the equation, you funnel massive amounts of money blindly into cap-weighted indices thereby creating a self-referential, perpetual motion machine that drives the prices of the winners inexorably higher.

As not-at-all-dangerous as that dynamic is, the situation is even safer and less disaster prone in the fixed income space. Take corporate bonds for instance. Everyone knows that retail investors are experts at evaluating opportunities in junk bonds and emerging market debt. In the same vein, no one knows more about duration risk in IG than Joe jack-off with his Ameritrade account. That’s why what’s needed are low-cost corporate bond ETFs that, in the case of high yield and EM debt, sport a super-safe liquidity mismatch that definitely won’t be laid bare in the event of a fire sale catalyzed by an acute risk off episode.

All of this is obvious, which is why there are so many ETFs now and it’s also why anyone who criticizes the proliferation of things like, say, fixed income ETFs, is a shady person and a paid shill for active managers who are just mad because their coke/hooker money has dried up in the age of low-cost passive investing.

Well speaking of shills for active management who are mad about not being able to afford coke and hookers, the BIS is out raising fresh concerns about fixed income ETFs. Specifically, the central bank for central banks (as the BIS is not-so-affectionately known), notes that the growth of passive bond funds could be encouraging borrowers to lever up.

You can read their take below and do feel free to summarily dismiss it just as you would any other take which doesn’t tout the rise of passive and ETFs as the best thing since Jesus turned water into sliced bread.

From the latest BIS quarterly report

The perspective of security issuers

Going beyond the impact on the prices of individual securities, growth in passive funds might also influence the decisions and profile of security issuers.

A general consideration is that passive investing may alter the relationship between issuers and investors. By design, passive funds invest in all securities included in the index they track. Unlike active investors, they cannot express their disagreement with the decisions of individual issuers by selling their holdings. A higher share of passive investors could therefore weaken market discipline and alter the incentives of corporate and sovereign issuers to act in the interest of investors.

Growth of passive bond funds, specifically, might encourage leverage by borrowers. Because inclusion in bond indices is based on the market value of outstanding bonds (that is, the face value of bond debt times its price), the largest issuers tend to more heavily represented in bond indices. As passive bond funds mechanically replicate the index weights in their portfolios, their growth will generate demand for the debt of the larger, and potentially more leveraged, issuers. From a financial stability perspective, there is a concern that this can act procyclically and encourage aggregate leverage. The analysis presented in Box A, which is based on a major global corporate bond index, suggests that passive bond funds do indeed obtain greater exposure to firm leverage than to firm size.

As passive funds grow, the mechanical trading impact of index inclusion or exclusion is likely to become more important for issuers. For instance, the higher the share of portfolios tracking an investment grade bond index, the larger the selling effect when a bond is removed from an index because of a credit rating downgrade.

Decisions around the country composition of indices can potentially have relatively large financial effects, given that they involve the combined weight of all securities from that country in the index. This is more so for smaller countries because the size of the fund asset base can be much larger than the underlying securities market. One example of a significant mechanical country trading effect is the reclassification in 2010 of Israel from emerging to developed market status by MSCI, an important provider of global benchmark equity indices. This reclassification resulted in about $2 billion of net equity fund outflows from Israel during the month in which the change came into effect. This occurred because Israel’s new weight in the developed equities index was smaller than its previous weight in the emerging equities index, and the value of fund assets tracking these two indices was not very different (Raddatz et al (2017)). Reclassification could also result in spillovers to other countries if the country being removed (or added) has a large index weight, obliging index funds to rebalance their portfolios to accommodate the change.

Corporate leverage and representation in a major bond index

This box examines the relationship between a firm’s leverage and its weight in a major corporate bond index, the Bank of America Merrill Lynch Global Broad Market Corporate Index. Data on corporate debt are matched with issuers in the index. A firm’s weight in the index is then calculated as the sum of the market value of its individual bonds, divided by the market value for all issues where there is matching firm data.

Regression results confirm that there is a statistically significant positive relationship between a company’s weight in the index and its leverage (based on either total debt or just bond debt; Table A, columns (1) and (2)), conditioned on the bond price. Although larger companies would be expected to have more outstanding debt, the coefficient on debt is about four times larger and more significant than the coefficient on total assets (column (4)). Specifically, a 1% increase in company debt is associated with a 0.025 percentage point increase in its weight in the index, compared with a 0.005 percentage point higher weight from a 1% increase in total assets.

Lack of data for some bond issuers could bias results if their leverage differs systematically from the average of the other issuers in the index. Since firm index weights are not normally distributed, we also run regressions using the log of the weight: the results are essentially the same.

Despite the above-mentioned concerns, the availability of benchmark indices may reduce issuance costs and improve issuance opportunities by supporting securities market development. For example, the development of a set of local currency bond indices in several major Asia-Pacific economies and the associated growth in passive funds have helped broaden and deepen Asian regional and local bond markets. Specific effects include the rise in bond issuance, increased market liquidity, institutional investors’ greater participation, and lower barriers to non-resident investors (Chan et al (2012)).