Data from Q4 2018 present a chance to assess liquidity strength in a less transparent corner of the fixed-income space
Aside from lower costs and simple diversification, one of the main draws of ETFs for investors has been liquidity. That’s a prime issue among institutional investors, who are facing heightened capital requirements that make holding bonds in inventory more expensive for dealers.
“As a result, despite the growing US bond market, it has become more challenging for institutional investors to source the fixed income exposures they need,” said Matt Tucker, head of Fixed Income Strategy for iShares at BlackRock, in a commentary this past December. Citing research from Greenwich Associates, Tucker said that 80% of institutional investors cited liquidity and low trading costs as a reason for using bond ETFs.
But the easy liquidity of the ETF vehicle may belie a critical risk, particularly for those with comparatively illiquid assets.
“[M]arket intermediaries such as authorized participants use the less transparent and less liquid over-the-counter (OTC) market for transactions in individual bonds,” wrote Reka Janosik, vice president for Risk Management and Liquidity Core Research at MSCI, in a recent note. “ETF investors may close their positions during market selloffs, with the result that intermediaries may offload their holdings into the OTC market.”
The upshot, Janosik said, is a possible liquidity shortage that worsens the market selloff, assuming that the high-yield bond market isn’t liquid enough to absorb the increased supply.
That raises questions for participants in the high-yield bond market: with a total of US$34 billion invested, high-yield bond ETFs currently account for slightly more than 2.7% of the space, according to IHS Markit data. Meanwhile, the daily average trading volume in high-yield bonds is reported at approximately US$7 billion.
“In the fourth quarter of 2018, redemptions of high-yield ETFs soared to approximately 25% of these funds’ assets under management,” Janosik said, referring to data from IHS Markit. “This wave of redemptions provided an opportunity to assess the strength of liquidity in the high-yield market.”
MSCI examined data from four specific days within the fourth-quarter selloff: October 8 and 10, November 14, and December 21, when net high-yield ETF redemptions exceeded 4.5% of AUM. Each of those dates came immediately after trading days with significant negative price returns in the broad high-yield market.
“To isolate the effect of ETF redemptions on bid-ask spreads — i.e., to gauge high-yield ETFs’ liquidity risk — we looked at the high-yield bonds held in ETF portfolios, while we used non-ETF high-yield bonds as our control group,” Janosik said.
The analysis revealed a minimal difference in bid-ask impact on both the ETF and non-ETF constituents, suggesting that ETF redemptions did not result in significant deterioration of liquidity. But on December 21, the difference in bid-ask spreads narrowed moderately from 14 to seven basis points, suggesting that ETF redemptions had some impact on liquidity.
“On balance, we interpret the data as suggesting that redemptions did not generally result in impaired liquidity in the high-yield-bond market,” Janosik said. “Nevertheless, looking forward, investors may want to pay attention to ETF redemption levels, since redemption spikes could have an impact on bond-market liquidity in highly stressed conditions.”