A bull run
ETFs are inundating the bond markets right now – to the tune of $32.5 billion in July alone, according to BlackRock’s monthly ETP survey. It was a significant uptick from June’s $3.2 billion, driven primarily by a surge of interest in corporate bond ETFs, which saw inflows of $13.8 billion in July, reversing the $9.9 billion outflows seen the previous month, with investment grade credit taking the lion’s share.
“ETFs have become a significant market mover, and their influence on market prices has become much more noticeable over the last 12-18 months,” agreed Michael McGill, senior portfolio manager for emerging markets at Aviva Investors, speaking to The TRADE. “They’ve definitely become a much bigger player, especially in emerging markets hard currency.”
“ETFs have become a significant market mover, and their influence on market prices has become much more noticeable over the last 12-18 months.”
European ETFs also saw a jump in July, attracting the highest monthly inflows in two years, with $2.2 billion in new blood flowing in. Much of this growth is down to changing market sentiment, as investors shift their focus to fixed income amid expectations of a significant growth slowdown and as rising interest rates pump up yields.
“We prefer investment grade (IG) credit over equities on a tactical horizon as we see a new market regime with higher volatility taking shape,” said BlackRock in an August research note. “We believe IG credit can weather a significant growth slowdown whereas equities don’t look priced for this risk.”
Yields are certainly on the rise, while prices are falling, meaning that opportunities abound. And investors are not just buying to hold – trading activity is also on the up, with 13 June seeing daily notional volume traded in bond ETFs hit an all-time high of $58 billion.
But what impact is this ETF activity having on the underlying market? It depends who you talk to.
The argument for
“Proponents of an expanded utilisation of bond ETFs argue that fixed income ETFs not only provide an additive source of fixed income liquidity and exposure but also a novel means of price discovery for the underlying cash bonds,” explained Colby Jenkins, strategic advisor at advisory firm Aite Novarica. “As such, they are seen as a panacea for the inefficiencies of the fixed income markets.”
“ETFs not only provide an additive source of liquidity and exposure but also a novel means of price discovery for the underlying cash bonds.”
Some take it even further, suggesting that bond ETFs are increasingly necessary shock absorbers to support wider market dislocations, and could help institutional fixed income traders navigate volatile market conditions, especially when the underlying cash bond markets run dry.
But others believe that the influx into ETFs is sucking up secondary market liquidity for the underlying cash bonds – contributing to the problem, not the solution.
The case against
“We’ve had some really huge ETF flows over the past month, and that rise in passive flow is exacerbating some of the other problems in terms of liquidity,” noted a source who wished to remain anonymous.
“The rise in passive flow is exacerbating some of the other problems in terms of liquidity.”
The issue is that ETF flows are, by and large, indiscriminate in the way that they execute. Whereas an active manager will usually have either a trader in-house, or use an outsourced service to access the market, passive portfolio managers tend to be more systematic, and use electronic platforms a lot more – even when the liquidity or the size of the trade doesn’t necessarily merit using a platform.
What can then happen is that in times of very low liquidity, these platforms make automatic offer or bid requests in high multiples, and when they get filled in some orders but not in others, they just keep asking over and over, which can push the market in either direction.
“They can also trade at a price that is not necessarily close to where the bonds are being quoted, which can then reprice the market to the wrong levels,” the anonymous source added.
“It can create a lot of problems for the dealer community, who are taking what risks they can, because they end up short or long and then find themselves priced out of their position instantly, making a loss. In emerging markets especially, we’ve had some large ETF inflows that have been driving the market, and pushing it into dislocation, and that’s a frustration.”
Another concern is that should the flows reverse, selling pressure within the secondary ETF space could spill over into the underlying cash bond market, placing undue selling pressure on an already highly illiquid market.
But “that may not always be the case,” said Jenkins. “For the most highly traded FI ETFs, previous examples of significant market dislocation for the underlying bonds to date have provided evidence that liquidity in the secondary market for bond ETFs surge with little drawn down effect on the underlying market via the primary create/redeem mechanism.”
The opportunity up-side
From a buy-side perspective, the biggest fear is the uncertainty – because no one really understands how long ETF flows will last.
“On the real money side, portfolio managers can usually get a sense of how investors are thinking and feeling toward the asset class, and whether there are inflows or outflows coming,” explained McGill. “But on the ETF side that is a lot trickier and can be different from day to day because no one knows how they’ll behave, or how long the flow will last.”
“You can try to figure out when the robots are buying and selling, and use them as a liquidity provider.”
For McGill, the solution to help manage portfolios more efficiently during volatile markets is to better understand ETFs themselves.
“Take look at the technicals, the net asset values (NAV), the richness, the cheapness… and then you can try to figure out when the robots are buying and selling, and use them as a liquidity provider,” he recommended.