Bond ETFs suck liquidity out of market in a crisis, academics say

Fixed-income exchange traded funds can suck the liquidity out of corporate bonds during times of market stress, potentially worsening price dislocations during crises, academics have claimed.

Bond ETFs are generally perceived as innovations that have enhanced liquidity and aided price discovery during market ruptures, offering a superior option than attempting to trade in the underlying bonds.

During the Covid-driven market sell-off in March-April 2020, scores of fixed-income ETFs plunged to unprecedented discounts to their net asset value.

With the benefit of hindsight, the prevailing view is that it was the relatively liquid ETFs that were trading at fair prices, and that many of the underlying bonds were simply not changing hands and were thus being quoted at stale, unrealistically high, prices. In this version of events, ETFs were the good guys, offering a tool for distressed sellers who needed to exit, or at least hedge their exposures, while also allowing bargain hunters to step in and steady the market.

However, academics from a trio of US business schools suggest that ETFs’ role is not always benign, and during market dislocations can actually worsen the state of the underlying market.

The potential problem stems from the creation and redemption baskets that ETF issuers trade with market makers known as authorised participants (APs) in order to handle inflows to, or outflows from, their ETFs.

Unlike equity ETFs, bond funds’ creation and redemptions baskets typically do not include every bond in the index they are tracking, as this can encapsulate hundreds, or even thousands, of separate issues.

In their paper, Steering a Ship in Illiquid Waters: Active Management of Passive Funds, the academics argue that in normal times a bond’s inclusion in an ETF basket makes the bond more liquid, as a random mix of creations and redemptions increases trading activity.

However, during a crisis, when many investors are rushing for the door, redemptions hugely outweigh creations. In that scenario, if a bond is included in the basket, the APs “may then become reluctant to purchase more of the same bonds, reducing their liquidity”, the paper said.

During the wave of selling at the height of the coronavirus crisis, “bonds heavily represented in redemption baskets became heavily represented in APs’ inventory”, it added.

“Given their balance sheet constraints, APs became reluctant to purchase even more of the same bonds in their role as market makers. Bonds present in redemption baskets thus lost their most natural buyers.

“When its own market makers do not want to buy it, a security can become quite illiquid.”

“The illiquidity of the underlying bonds can be partially ascribed to inclusion in redemption baskets,” added Yao Zeng, assistant professor of finance at the Wharton School of the University of Pennsylvania and co-author of the paper.

If this is true, then the fast-growing corporate bond ETF sector may be gumming up the underlying fixed-income market during crises, a problem that might be expected to intensify as the ETF market continues to grow.

The paper comes after both the IMF and the Bank for International Settlements raised questions about the impact of ETFs during stressed markets.

However Dan Izzo, chief executive of GHCO, an ETF market maker, disputed the latest findings.

Izzo argued that the causality ran in the opposite direction — it is because some bonds are illiquid that they increasingly feature in redemption baskets as sell-offs intensify, not vice versa.

He explains it thus: on the first day of a crisis, an ETF issuer might publish a preferred redemption basket but the APs might say they can only accept, say, 80 per cent of it, as the rest is too illiquid.

If the issuer agrees to that trade, by day two, it is increasingly desperate to get rid of some of the illiquids, as the ETF’s tracking error to its underlying index may be rising. The share of illiquids in its desired redemption basket might thus rise from 20 per cent to 40 per cent.

This process continues until either the APs reluctantly accept the illiquid paper (or the equivalent cash proceeds if the issuer itself sells the illiquids and puts the proceeds in the basket) or the selling pressure abates and inflows turn positive.

“The illiquidity is causing the issuer to put it in a more concentrated weight in the basket to try and either get us to take it from them or find a price,” said Izzo, who argued that the rise of ETFs had actually increased liquidity during periods of market stress.

“The traditional approach across the entire fixed-income industry to a bond crisis is to do nothing. The default behaviour is that everyone — outside the ETF creates and redeems — just turns their chair, looks away and says ‘we will wait it out’.

“If the bonds don’t trade then you don’t have to write them down. For illiquid bonds, you can’t even find a bid or an offer.

“ETFs have brought liquidity into the market at times of crisis where it has never existed before,” added Izzo, who said that during the Covid crash GHCO bought bond ETFs at a 20 per cent markdown and held them on its books, a strategy that ultimately proved highly profitable.

MJ Lytle, chief executive of Tabula Investment Management, a bond ETF specialist, and a former Morgan Stanley fixed-income trader, also disputed the findings.

He accepted that as a sell-off intensifies, illiquid securities would tend to carry a greater weight in redemption baskets as issuers strive to keep their index tracking in alignment.

However, Lytle said he did not “get the idea that a bond gets tainted” by being in a basket during a period of market stress.

“I don’t see any evidence of a systemic problem.”