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Bond Market Liquidity and the ETF Bogeyman

Many investors still don’t fully comprehend the function that fixed-income ETFs serve or how they work.

Ben Johnson, 07/31/2015

The specter of rising interest rates has brought the topic of bond market liquidity to the fore. Over the past decade, assets in fixed-income mutual funds and exchange-traded funds have more than tripled while traditional liquidity providers' role in bond markets has greatly diminished and trading volumes have shriveled. These opposing trends have fueled concerns that higher rates could result in mass selling into a market that appears ill-prepared to deal with a rush to the exits.

ETFs--particularly those investing in high-yield bonds and bank loans--have been singled out as an area of specific alarm, given their unique structure and perceived superior liquidity. Some of these fears could prove to be perfectly reasonable--though most of them aren't unique to ETFs. The ETF-specific concerns serve as evidence that many investors still don't fully comprehend the function that fixed-income ETFs serve or how they work.

Liquidity Has a Price
Liquidity is a multidimensional concept. Its most important dimensions are time, size, and price. Together they represent the "cost" of liquidity. Investors like to transact quickly in large quantities with little effect on security prices. Liquidity is abundant and inexpensive in markets with ample buyers and sellers making frequent transactions. Stocks in the S&P 500 are very liquid. Liquidity is relatively scarce and more costly in markets with fewer buyers and sellers that transact less frequently--like bond markets.

Bonds are not stocks. Bonds are often bought with the intention of being held until maturity. Thus, they are traded far less frequently than stocks. Also, there is no central exchange for bonds as there is for stocks. Bonds are traded over-the-counter. Buyers and sellers may link up over the phone or via instant messaging. The process can be time-consuming and costly. Additionally, bonds are not standardized. Citigroup's C stock has a single listing, but the firm has over 1,000 different bonds, each of them unique. This fragmentation further fosters illiquidity.

Liquidity also varies depending upon prevailing market conditions. In good times it is plentiful and inexpensive. In bad times it is hard to come by and costly.

If market fundamentals turn south and bond investors sell en masse, the cost of liquidity will rise. It will manifest chiefly in the form of market impact (that is, a negative effect on prices). This will affect all sellers regardless of whether they have exposure to the asset class via individual securities, a traditional mutual fund, or an ETF. A downdraft would have a permanent effect on sellers (realized losses) and a temporary one on holders (paper losses) and might present a buying (or arbitrage) opportunity for others. Thus, those who should be most concerned about the effects of panic-selling in the bond markets are those with the greatest proclivity to panic and sell. Long-term investors and opportunistic buyers won't ultimately bear the direct costs stemming from the activity of their more excitable counterparts and may actually stand to benefit from it.

The New Kid on the Block
ETFs are the new kid on the block in the bond market. The first fixed-income ETFs were launched in July 2002. The first high-yield ETF, iShares iBoxx $ High Yield Corporate Bond ETF HYG, made its debut in April 2007. More recently, there have been ETFs launched that track even less-liquid corners of the market. PowerShares Senior Loan ETF BKLN listed in March 2011; it tracks a benchmark composed of bank loans.

The repackaging of relatively illiquid and risky instruments in a wrapper that boasts intraday liquidity has been a welcomed by many investors, while others have viewed these funds as fraught with risk and singled them out as a potential source of incremental volatility and potential market instability. As I see it, the latter cohort's fears are overblown and reflect a lack of understanding of ETFs.

Ben Johnson is Morningstar’s Director of European ETF Research.

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