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David Coombs: Bond ETFs – Tracking the haircuts

Beware the tripwires of investing in high-yield fixed income varieties

Way back in the late 1980s, while investigating one of the first ‘flash crashes’, the US markets regulator suggested creating tradeable baskets of shares that could improve liquidity for the overall market.

This suggestion was jumped on by an American stockbroker, which proposed the first exchange-traded funds just months later. Unfortunately for that stockbroker, the US regulators were slower than Canadian authorities, so the first ETF was actually a tracker of the Toronto Stock Exchange 35 index.

Now ETFs are a trillion-dollar industry that has spread beyond North America into foreign stockmarkets, commodities, factors such as momentum and value, and fixed income.

As we have seen, the coming of ETFs hasn’t put an end to flash crashes. However, they are a tremendous source of liquidity, particularly in commodities and stockmarkets, as they have enabled more investors to access areas previously restricted to very wealthy and specialist investors.

We use ETFs all the time, whether to make short-term adjustments to our funds and the risks they take or to buy things we otherwise couldn’t, such as commodities. But there is one area we will not tread with ETFs: high-yield fixed income.

Because of regulation and shifts in the way investment banks work, the latter no longer have large stocks of bonds stored away in their accounts. Now, instead of being an actual market maker, they are more akin to real estate: they are matching buyers and sellers.

Not only that, but it could be argued that investment banks used to have an interest in ensuring that bond prices didn’t crater completely – they owned stacks of them. Nowadays they have little skin in the game, so greater swings in the value are of little worry to them.

How to…decide whether ETFs are right for your clients

These days, when markets get dicey, institutional investors are more inclined to wait it out. With no bank inventory and zero appetite for trading on their own book, market illiquidity is even more chronic. We have noticed that, during spicy market conditions, the European bond market decamps to the pub en masse until everything blows over. Well, obviously they aren’t all at the pub, but trading effectively comes to a standstill.

What happens if ETFs become a significant player in the higher-yielding bond markets? ETFs offer retail investors quick and easy access to assets that were previously out of reach (unless you had a spare £100,000 or so and a broker that you trusted). Growth in bond ETFs would bring more investors into the market, but I worry if this liquidity would be unbalanced.

Retail investors are pretty flighty when things get rough. Who would be standing on the other side of that trade, especially when it’s widely known that retail investors tend to arrive late? They will be trying to get out of bonds that most of the institutional money will already have left or never entered to start with.

Could the market cope with thousands of frightened people trying to pull their money out of ETFs? Vehicles offering instant liquidity for potentially very illiquid assets are a recipe for trouble.

Who would be the marginal buyer of the forced sales by ETFs facing 20 per cent outflows? What price discount would ETF managers have to take when selling their bonds to raise the cash needed for a flood redemption? What would that do to the wider market?

I’d view high-yield bond ETFs as an opportunity to make short-term gains in times of extreme dislocation

The tracking error of these ETFs could blow out massively during times of stress. Massive divergence from underlying performance would come as some surprise to investors who believed – who were told – that they were simply ‘buying the market’.

Now, the beauty of ETFs is that they allow large investors to make money by arbitraging the difference between the price of the ETF on the market and the underlying price of the assets within it. So, if the price of the ETF rises above the net asset value of the shares or bonds in its portfolio, banks and other institutional investors can sell the overpriced ETF and buy the underlying shares, making a virtually riskless profit.

Similarly, if the ETF price falls below the NAV, they can buy the cheaper ETF and sell the more expensive stocks. This feature gives investors the incentive to keep the ETF price close to its NAV.

As we’ve seen with equity ETFs, however, sometimes this doesn’t work during extreme scenarios. And executing such arbitrage trades is much harder in an over-the-counter market like corporate bonds. Your dealing is more laborious, expensive and opaque.

Bond ETFs aren’t as prevalent as they are in stockmarkets yet. But, when they are, they will be some of the largest holders of individual bonds – just as their equity cousins now litter the share register of many listed companies. At that point, cue a very interesting market experiment. And a very dangerous one, in my opinion.

For me, I wouldn’t see high-yield bond ETFs as a way to make core investments in bonds and adjustments to my portfolio’s credit holdings. Instead, I’d view them as an opportunity to make short-term gains in times of extreme dislocation – when the price of an ETF diverges wildly from the value of its assets. But I wouldn’t be buying them at any other time.

David Coombs is head of multi-asset investments at Rathbones


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