How New Financial Regulation Could Impact Bond ETFs

ETF Trends

The exchange traded product business has grown by leaps and bounds over the past several years with the number of ETFs and ETNs trading in the U.S. rising to around 1,500 with about $1.5 trillion in assets under management. On a global basis, the totals are 3,660 funds with over $2.1 trillion in AUM, according to new research published by Credit Suisse.

The Swiss banking giant forecast further growth for the industry, but noted regulation and the size of some ETFs could impact market liquidity.

“While we continue to expect the overall ETF market to grow 5-10% (annualized) over the next five years, we believe regulation (Basel 3, Volcker Rule) and the size of individual ETFs relative to the underlying market could impact ETF trading liquidity (bid-ask spreads and bid-NAV spreads), especially in days of extreme market volatility,” said Credit Suisse in the note.

ETF market liquidity has been a marquee issue for the industry and market participants this year, particularly as liquidity pertains to less-liquid market segments such as emerging markets equities and high-yield bonds. Earlier this year, concerns centered on ETFs tracking less-liquid sectors of the fixed-income market, such as corporate junk bonds and muni bonds. Some of these products traded at discounts to net asset value (NAV) during the May-June volatility. [Digging Deeper Into Bond ETF Liquidity]

Credit Suisse noted that Basel 3 and the Volcker Rule “could limit ETF trading partners in the secondary and primary market, and also limit the inventory that external traders carry.” The bank did note at that even if some ETFs started trading like closed end funds, a scenario Credit Suisse does not view as likely, ETFs are still a low-cost, tax-efficient, highly diversified tool for investors and that ETFs will continue to pilfer share from the actively managed world.

High-yield bond ETFs, such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays Junk Bond ETF (JNK) , were at the epicenter of the May/June liquidity debate.

For example, the two largest HY bond ETFs (HYG and JNK) control about 90% of the HY bond ETF market and they trade $500M per day on average. While this level is about 10% of the underlying volume in the entire HY bond market, remember that the secondary trades are actually not impacting the underlying bond market; only the primary trades in the creation/destruction process impact the underlying market. Accordingly, in June we estimate that selling pressure only caused about 700M of net destruction of HYG during the entire month, which is slightly more than one day’s volume for both large ETFs (but significantly smaller than the volume for the underlying securities),” said Credit Suisse in the note.

The bank pointed out that when HYG did trade below its net asset value, much of the discount had to do with the fact that 90% of the ETF’s holdings do not trade everyday. Credit Suisse is not the only bank to chime in on the high-yield bond ETF liquidity issues.

Last month, Citigroup said junk bond ETFs such as HYG and JNK are “structurally sound.” Citi said these funds operated as expected during a tumultuous period, trading continuously while providing liquid exposure to the high-yield bond market. [Junk Bond ETFs Surviving And Thriving Again

“Specifically, 90% of the bonds in the HYG do not trade daily, so the HYG ETF will reflect the real time value of the underlying bonds before the actual bonds do because there is less liquidity in the cash bond market. Accordingly, the price of the ETF is a function of (1) bid/ask spread of the underlying securities in the ETF, (2) demand of the ETF on the exchange (secondary market), and (3) the level of risk carried by the external brokers,” said Credit Suisse.

ETF Trends editorial team contributed to this piece. Tom Lydon’s clients own shares of HYG and JNK.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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