In a startling disconnect, ETF and non-ETF managers take diametrically opposing positions about the tradeability of the US$7 trillion corporate debt market.

According to managers of some corporate bond funds, the liquidity of the market they’re investing in has taken a severe turn for the worse during the last five years.

"Prior to the banking crisis I could have turned over my portfolio in three months – now it takes much longer," Chris Bowie, manager of a corporate bond fund at Ignis, told the Daily Telegraph recently. "Instead of being able to push through £150 million in a day you have to stagger it, £3 million here, £4 million there. You have to manage positions much more slowly."

Ian Spreadbury, manager of the £3 billion Fidelity Moneybuilder Income fund, the fourth largest corporate bond fund in Britain, told the newspaper he feels the need to keep a "liquidity bucket" in his portfolio, made up of cash and gilts, to meet potential redemptions.

"In a situation when there were substantial outflows, if you were fully invested in corporate bonds you would struggle to pay investors," Spreadbury told the Telegraph, alarmingly.

M&G, the UK’s largest manager of corporate bond funds, recently started to turn new investors away, the Telegraph says, reflecting similar concerns. M&G’s move may have been prompted by the UK regulator, the FSA, which reportedly sent a letter to a number of investment firms two months ago, asking them to make sure they could meet potential redemption requests.

In the US, as we reported a couple of months ago, fund management giant Vanguard also stopped inflows into a large corporate bond portfolio, apparently worried about the scale of recent hot money inflows.

But if you listen to ETF evangelists, you get the opposite picture: ETFs are actually stepping into the role of the traditional market maker and playing a transformational role in providing corporate bond liquidity, the market’s leading issuer tells us.
In a recent iShares blog, Matt Tucker, head of fixed income strategy at the firm, argues that:

“During the financial market implosion at the end of 2008, trading volume in markets like corporate bonds fell by as much as 50%.  Why?  Liquidity in the bond market is supplied by broker/dealers, and since many of these firms were struggling to stay afloat, they pulled back from making markets in bonds.  Because of this, many investors discovered an alternative way to access bonds – through fixed income ETFs.  Fixed income ETF trading volumes spiked, increasing 800 to 1000% for some funds.”

“Given that ETFs are not just another way to buy fixed income, but are transforming the fixed income markets themselves, the sky is the limit for these game-changing products,” Tucker concludes.

iShares recently predicted that fixed income ETFs would reach US$2 trillion in size over the next decade, a seven-fold increase from the current level.

It’s worth paying particular attention to what Tucker is saying. His assertion that ETFs are providing liquidity in bonds is a striking inversion of issuers’ traditional argument that “the fund is as liquid as the underlying asset class”. Tucker is effectively arguing that “if the underlying asset class isn’t that liquid, don’t worry, the fund can provide liquidity by itself”.

It’s clear that banks’ capacity to make markets in corporate bonds has fallen dramatically since the financial crisis. A chart in a recent Towers Watson publication shows inventories of corporate bonds at primary dealers falling by a factor of five from mid-2007 to today.

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