Bond Market Liquidity and the ETF Bogeyman

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.

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,

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.

Organized Chaos One of the chief functions that fixed-income ETFs serve is to organize liquidity. They assemble a collection of relatively illiquid, nonstandard securities or loans into a single standardized basket that trades like a stock on an intraday basis. In doing so, they create a new avenue for investors to attain exposure to a given segment of the fixed-income markets. This route is more efficient than sourcing individual securities or loans. It also provides a broader and deeper pool of potential liquidity. There are far more prospective buyers and sellers in the secondary market for ETF shares than there are in the markets for each of the underlying securities or loans that comprise these funds' portfolios. Finally, because they are traded in real time during normal market hours, these funds provide an unprecedented level of transparency around fixed-income pricing. Fixed-income ETFs bring a semblance of order to a cluttered landscape.

Everybody Sells Most of the trading activity in fixed-income ETFs takes place in the secondary market. This is where investors trade shares of ETFs back and forth between one another. This trading activity does not involve any direct transactions in the funds' underlying components.

Concerns regarding fixed-income ETFs' potential effect on their underlying markets center on a mass-liquidation scenario. In this event, the supply of ETF shares on the secondary market would exceed demand (there would be more sellers than buyers). This would lead ETFs' prices to fall to below their net asset values (they would trade at a discount). In this event, the most likely providers of liquidity (buyers) would be market makers. Discounts will ultimately widen to the point where it becomes profitable for market makers to step in and buy ETF shares "low" with the prospect of subsequently selling the underlying securities "high." By exploiting this arbitrage opportunity, market makers will reduce the supply of ETF shares in the secondary market, the supply/demand balance will be restored, and discounts will ultimately collapse.

The scenario described above is not hypothetical. This process has been at work since the very first ETF,

SPY, was launched in 1993. Fixed-income ETFs, while still relative newcomers, have been stress-tested in real time. They functioned remarkably well during the worst days of the financial crisis. In fact, at certain points they were one of the only remotely reliable sources of liquidity and price information. This pattern has subsequently repeated, as evidenced by the spikes in fixed-income ETF trading that have coincided with intermittent bouts of volatility in the bond market--most notably, the 2013 "Taper Tantrum."

But Liquidity Still has a Price Fixed-income ETFs serve to organize liquidity and have functioned well in times of crisis, but they have not and will not change the fact that liquidity comes at a cost. In the case of fixed-income ETFs, that cost takes the form of bid-ask spreads, market impact (on the ETFs' prices), and premiums and discounts to net asset value. The cost of liquidity can be volatile and will surely increase in the face of a mass exodus from fixed-income markets. This is not unique to ETFs. What is unique about them is the level of transparency they provide (in the form of widely available intraday prices and a ready proxy for the cost of liquidity) and the additional layer of liquidity they've added to the market in the form of secondary-market trading.

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