[This article previously appeared on our sister site, IndexUniverse.eu.]
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.
But can firms like iShares really take up the slack and take over the role of the big investment banks, who face higher capital requirements for their trading activities, as well as a crackdown on proprietary risk-taking?
In its marketing literature, iShares makes a virtue of the fact that its parent company’s size allows it to match many buy and sell orders internally, bypassing external liquidity providers.
“Given BlackRock’s leading market position, iShares has plenty of opportunities to cross bonds both internally between its own funds and externally with other institutional investors,” the firm says in a recent publication, “Managing iShares Fixed Income ETFs”.
It’s clear that BlackRock has major ambitions for its bond trading activities. In an April Wall Street Journal article, BlackRock’s head of global trading, Richard Prager, said that the firm can offer significant cost reductions to investors. "If there's a saving available to clients, we want to give it to them," the WSJ quotes Prager as saying, implying that investment banks have traditionally overcharged for making markets.
Details of BlackRock’s planned bond trading platform are scarce, though it’s supposed to be launched by the end of 2012. But some fundamental questions remain. Crossing trades between willing buyers and willing sellers and adding a fee on top for doing the matching is one thing.
Providing capital to ensure that buyers and sellers can enter and exit markets at any time is quite another.
For investors in ETFs, such questions matter. Since ETFs effectively promise instant tradeability, and that tradeability depends on the ability to buy and sell the bonds or shares in the index, a corporate bond tracker relies on there being deep-pocketed, steady providers of liquidity at the end of a chain of transactions.
If BlackRock’s bond trading venture turns out to be more a crossing platform than anything else, the claims that the firm’s ETF promoters are making about the transformational role of their funds in the corporate bond markets appear to rely on a dangerous circularity.
The recent compression in bid-offer spreads in corporate bond ETFs may be more the result of increased investor demand than of any fundamental change in the liquidity of the asset class, in other words.
Perhaps BlackRock has larger-scale ambitions, aiming to provide some of the traditional “warehousing” functions of investment bank dealers. While this would be an opportunistic attempt to capitalise on the current difficulties of banks, such a move would raise difficult questions about capital requirements and potential conflicts of interest.
In the meantime, if you’re an investor in corporate bond ETFs, it must be puzzling to hear the managers of actively managed bond funds worrying about liquidity, while you’re hearing only optimistic noises.
It’s worth following this debate closely. While interest rates remain near zero and investors chase yield by buying bond funds en masse, questions about the tradeability of bond funds may seem moot. But eventually we’ll see the iShares hypothesis tested.