Bond ETFs and the liquidity crunch

How will providers keep the supply chain open?

October 1, 2014

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tap water dropTwenty years ago, bonds were seen by many as the slightly boring, unloved part of a portfolio—something that quietly ticked along, keeping up with inflation and generally staying out of trouble. Stocks were the big stars—and that’s what everyone talked about.

Today, fixed income has come into its own. Bond are big news—and investors are all over them, with many shedding their exposure to stocks and adding more and more bonds.

Liability-driven investing has made bonds an even bigger part of DB pension plans. Junk bonds have taken on a new and decidedly less trashy moniker: high yield. There’s even a “bond king”—Bill Gross, who makes news with every tweet or media comment (em…especially last week when this happened).

Suffice it to say that bonds are cool….Unless, of course, you’re an issuer. While investors have found their love for bonds of all stripes, issuers are cooling on them—and that’s turning off the supply tap at a rather alarming rate. Last week, this story from Reuters contributed to the conversation about the shrinking corporate bond space. Bond liquidity has been hurt by new regulations and capital requirements that have forced major investment banks to cut inventories of fixed income products.

As corporate bonds become harder to find, liquidity is becoming a big problem.

Which is hard on bond exchange-traded funds (ETFs). ETFs trade like stocks, but when the underlying assets get scarce, it can leave ETF providers scrambling for substitutes. As Reuters reports, index funds have less wiggle room than active bond managers since they have to track the index (not beat it). But the substitute doesn’t always cut it—and some now have to go outside their benchmark index to find replacements for those hard to get products.

That can lead to returns that severely lag the index.

For Canadian institutional investors that have put a big focus on fixed income ETFs, the potential for a liquidity mismatch is a real risk. As I wrote a few weeks ago, many Canadian institutions are using fixed income ETFs—and they’re playing a more strategic role.

Bottom line: as bond liquidity becomes more of a challenge, institutional investors will need an even better understanding of how these products work—and what they’re using to replicate the index. With bonds becoming scarcer, even ETFs won’t be able to escape the liquidity trap.

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