Investors voice concerns on bond ETFs

Unexpected behaviour and liquidity risks are a cause for caution

Investors voice concerns on bond ETFs
Bond ETFs’ divergence from their underlying assets, as well as liquidity concerns, is causing some investors to be more wary of the vehicles.

Bond ETFs have grown in popularity, with data provider ETFGI reporting US$81 billion worth of inflows into the vehicles in the first six months of 2017 — 19% more than the record set at the same time last year, according to Reuters.

However, during the recent sell-off in bonds caused by hints of a stimulus scaleback from European Central Bank chief Mario Draghi, some bond ETFs did not behave as expected.

Government bond ETFs and high-yield corporate bond ETFs from Deutsche Asset Management stayed close to their indexes. Two major European ETF providers said that for most of their products, the tracking difference — which measures the gap between a tracker and its underlying bond index — remained stable.

But for some products on the market, the needle on the tracking difference jumped. “On a day like [the one when Draghi made his statement], you could see some funds that were not working the way they were supposed to be working,” said Antoine Lesne, head of ETF strategy and research for EMEA at SPDR.

Changes in the tracking difference could be due to an ETF provider making an active decision to deviate from an underlying bond index. Such a move could pay off — but it could also backfire.

Another possible issue, according to analysts, comes from the recent significant inflows into ETFs in relatively illiquid areas, such as emerging-market debt and high-yield corporates.

“Investors are concerned about the strong inflows into emerging market ETFs and the potential forced selling should the risk-on environment reverse,” said a note issued by Morgan Stanley analysts.

iShares, BlackRock’s ETF business, has reported that year-to-date flows into emerging-market debt ETFs reached US$13.6 billion in June, already surpassing the whole-year record for last year.

“In the more exotic, niche strategies, if the ETF needs to sell, it's not very clear there would be someone on the other side of the market to bid for the bonds,” Vincent Deluard, head of global macro strategy at INTL FCStone, told Reuters.

ETF providers were quick to downplay the risks, however. “The markets are so huge that no ETF is so big it could create an issue,” said Michael Mohr, head of fixed income product development at Deutsche Asset Management.

“Emerging market bonds are less liquid, but if you compare the assets under management in ETFs to the total assets in that market, the ratio is still very small.”

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