The author is a director of ETFs at Richard Bernstein Advisors
Providing more liquid funds to facilitate transactions is the main function of financial markets. Before the stock markets, the only way to participate in company ownership was to actually own part of the company. Before the futures market, you would have had to sell pork bellies and cotton in a physical marketplace. Markets trade instruments that are more liquid than their underlying assets.
Fixed income exchange-traded funds can be a route to much-needed liquidity in bond markets, just as commodity futures provided liquidity to physical markets and stocks provided an easy transfer of corporate ownership.
Despite well-developed and liquid markets for many asset classes, bond markets remain notoriously illiquid. Since the global financial crisis, capital requirements for major banks have become stricter. Traders’ balance sheets contain a fraction of the stock of corporate bonds they previously had.
Adding to the liquidity problems, central banks around the world have been buying prodigious amounts of government and mortgage debt, effectively cornering the market and removing much of the “float” in securities that should be the most liquid in the world. The Federal Reserve once owned more than 50 percent of the 10- to 20-year Treasury bond market. With such market share held by a single company, it should come as no surprise that bond liquidity has dried up and volatility has increased.
Fixed income ETFs could offer a solution as multiple avenues to liquidity allow investors greater flexibility. First, ETFs are traded on an exchange and do not require a dealer to place a bid or offer. This alone creates advantages as there is real-time pricing for fixed income ETFs that does not exist for individual bonds.
Investors may not be fully aware that the fixed income ETF market has replaced the underlying bond market to set the price discovery for many fixed income assets. Pricing is always driven by the pricing of the most liquid market, but some argue that an ETF doesn’t work properly if it’s trading at a discount to the underlying assets.
However, the underlying bonds are not traded and therefore cannot be valued accurately. If the underlying instruments were traded, they would likely be trading at prices that differed significantly from their last actual trade, whenever that was the case. This is like the fallacy that private equity and debt investments are less volatile than similar public investments.
You cannot obtain an accurate pricing unless an asset is traded or marked to market. Second, ETFs can be created and redeemed across the most liquid basket of securities that do not require a forced sale on the open market. Ironically, the liquidity in these bonds has caused the rest of the bond market to become less liquid.
Improved liquidity has not come about without its doubters. Some have proposed more liquid fixed income ETFs that contain illiquid underlying securities (bonds) that risk financial disaster. However, countries, communities, corporations, and even our own mortgages, rely on the bond market and its investors to ensure our economies do not collapse financially. However, this cornerstone of finance is rarely traded, making pricing difficult, inefficient and costly for everyone. ETFs appear to be part of the solution rather than the problem.
Fixed income investors may be totally unprepared to manage a changing macro landscape, where higher inflation could require more tactical asset allocation decisions than has been required in the past 40 years. The inherent illiquidity of the bond market will hamper active management and the role of fixed income ETFs is expected to increase.
Even in times of volatility, capital flows into fixed income ETFs, which leads to more price transparency and liquidity. For example, during broader market turmoil in March 2020, the largest corporate bond ETF — the iShares iBoxx $ Investment Grade Corporate Bond ETF, known by its ticker LQD — traded at significantly more volume on a daily basis than before or since. Due to significantly larger trading spreads, there were hardly any individual bond transactions at the time. Bond ETFs weathered the storm and were the only way to trade risk appropriately.
Going forward, investors need to be aware of how their bond portfolios need to change. Given the macro liquidity, economic and earnings landscape, bond ETFs, not individual bonds, offer the best odds and opportunity for survival.
Michael Contopoulos, Director of Fixed Income at Richard Bernstein Advisors, contributed to this article. The RBA invests in fixed income ETFs, but currently does not hold LQD in any of its portfolios
Comments are closed.