Volume in the corporate bond market has dried up so much that it may pose a systemic threat, at least according to FactSet. A November 25th report from Dave Nadig, Director of Exchange Traded Funds for research firm FactSet, highlights the growing lack of liquidity in the U.S. corporate bond market.
Nadig notes: “…only about one-third of corporate bonds actually trade more than once every few months, and just 11% of the listed corporate bonds represent almost 60% of the actual dollars trading in corporate bonds, according to Tabb group…The dealer market has collapsed, and all that’s left are investors trading the same few bonds back and forth, leaving pricing services guessing with bigger and bigger margins of error on the real value of illiquid debt.”
The problem with corporate bond market manifests in ETFs
According to Nadig, corporate bond ETFs are not nearly as “liquid” as it might appear.
Keep on mind that ETFs only trade in line with their underlying securities because authorized participants are profit motivated to make or dispose of new shares through the creation and redemption process. If there is a premium, the APs can sell at that premium and make new shares by delivering the underlying securities. If the ETF is at a discount, they can buy the cheap ETF shares and returning them to the issuer for a basket of underlying securities.
However, if the market can’t practically deal with the volume implied in making or redeeming shares, the APs are motivated to let the price move until the gap is so wide they are guaranteed to make money. Moreover, given there are many APs all trying to book a profit, when the ETF gap widens and remains wide, it means there are “costs and risks that may not be obvious just looking at the numbers.”
Nadig goes on to explain that for corporate bonds, the problem is that the underlying markets cannot handle large amounts of creation and redemption, so the flow of money into or out of corporate bonds ETFs nearly always forces (an often substantial) premium or discount.
The above chart from corporate bond ETF HYG in 2012 (when there was an obvious opinion shift on junk bonds to analyze) illustrates the problems with consistently large premia and discounts with the EFT.
There is no question that HYG provides a great deal more liquidity than the underlying bonds, but as Nadig points out, “that’s what makes the SEC and skeptics nervous, because that on-screen liquidity can dry up. Looking under the hood, the average daily dollar volume in the underlying bonds is just $3.4 million:”
He goes on to note that this liquidity issue impacts almost all of the largest corporate bond ETFs today, including the the investment-grade and short-duration sector. Nadig highlights that even the most liquid corporate bond ETF (the iShares iBoxx $ Investment Grade Corporate Bond ETF) just trades $4.7 million per day in its underlying bonds, and short term bonds trade even less than the long-term securities.
Finally, Nadig notes that proposed new SEC regulations requiring that 85% of a mutual fund or ETF comprise positions that could be liquidated within seven days without market impact could lead to the closure of all corporate bond ETFs, but he says it’s much more likely the SEC rules will be revised (it’s probably too much to hope anything significant will be done to address the serious corporate bond market liquidity problem).