It’s time for another edition of “credit ETF implosion question begging”, this time courtesy of Adam Schwartz, a 39-year-old who runs something called “Black Bear Value Partners”.
Apparently, Schwartz is in the camp of folks who believe the inherent liquidity mismatch in high yield (and other) credit ETFs will ultimately cause the vehicles to implode at some point, an opinion regular readers know I share – sort of.
There is a liquidity mismatch in those products – period. The ETFs offer intraday liquidity against underlying assets that in many cases aren’t very liquid. That’s a philosophical contradiction and no amount of financial engineering or circular reasoning can fix it.
The problem with betting on it to break is that, generally speaking, the market conditions that would prompt such an event would be so acute that it’s not entirely clear whether critics of those products are actually saying anything worth saying when they suggest they (the products) would implode in a crisis.
And see, that’s where this gets tricky, which is why my own view on this subject has evolved over the years. I used to be squarely in the camp of high yield and emerging market debt doomsayers, but I eventually came to realize that because the type of fire sale conditions that would cause those products to buckle would likely create so many other opportunities to profit on the downside, it’s hard to say, definitively, whether one is just stating the obvious by saying the products would fold with everything else in the event the financial apocalypse comes calling.
What worries me, though, is that a lot of the people who defend those products don’t appear willing to adopt the above argument. That is, proponents of those vehicles could simply say something like this: “Well sure, if there’s a fire sale for high yield and emerging market bonds, the ETFs are going to plunge, but think about what kind of environment that would entail and tell me how likely that is to happen.” Instead, they (credit ETF proponents) habitually insist that the liquidity mismatch doesn’t exist, a patently absurd contention that, again, flies in the face of common sense.
The contention that there’s an underlying liquidity mismatch is incontrovertible. Howard Marks and Carl Icahn have variously maligned that structural problem, but they’re hardly the only ones. I have yet to read a refutation of their criticisms that doesn’t essentially beg the question by positing some semblance of benign market conditions. You cannot promise intraday liquidity against a basket of relatively illiquid assets. It’s philosophically impossible. Obviously, it can work for a while (and theoretically indefinitely) by way of an intervening mechanism that allows participants to arb away disconnects. But if that arb relies on people not being in panic mode or being otherwise willing to catch falling knives, well then it stands to reason that in a pinch, the intervening mechanism that allows for the transformation of illiquid assets into ETF units with intraday liquidity will cease to function. At that point, the ETF is only as liquid as the assets it represents.
In the post-crisis regulatory environment, the Street is less willing to lend its balance sheet in a pinch, and that relative reluctance has the potential to exacerbate this situation.
“Dealers curtailed their market-making activities as a result of both new regulations as well as changes to dealer risk appetite and policies”, BofAML’s HY team wrote last month, on the way to reminding you that “the days of multi-billion dollar inventories of HY bonds on bank balance sheets came to an end shortly after 2008.”
The bank goes on to note that over the past several years “aggregate dealer inventories in HY rarely exceed $5 billion” which stands in stark contrast to “a $1.3 trillion market by size and against $6-8 billion of average trading volume it generates in a given day.”
(BofAML, FINRA, Bloomberg, Fed)
For what it’s worth, BofAML says in the same note that they “do not count [themselves] among doomsayers that predict a severe dislocation in corporate credit as a result of liquidity constraints.”
So there’s that. And again, let me just reiterate that after years of talking to people about this, exactly no one (not a single, solitary person) has been able to explain to me definitively why Howard Marks, Carl Icahn and other critics are wrong about what would happen in a fire sale scenario.
That appears to be what the above-mentioned Adam Schwartz is staking his small-ish fund on. According to Bloomberg, Adam (who manages “mostly his own cash”) has dedicated half of his notional exposure to what sounds like simple shorts and plain vanilla put options on credit ETFs.
As far as IG credit goes, he’s essentially betting on fallen angel risk, while in high yield and EM bond funds, it sounds like he’s just betting on the vehicles collapsing as the liquidity mismatch manifests itself in authorized participants refusing to … well, refusing to participate. Here are a couple of short excerpts from Bloomberg’s piece (which you can read in full here):
In a rout, where secondary liquidity in the ETF evaporates, APs — the only parties able to trade directly with the ETF — will be compelled to redeem shares directly with the funds in exchange for bonds. But they’ll balk at receiving less-desirable securities, Schwartz believes.
Anxious to maintain orderly trading, the funds will give away their most liquid securities, leaving a portfolio clogged with distressed and illiquid notes. At some point, APs will refuse to transact with the fund, sending the ETF shares into a death spiral.