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Liquidity Concerns in Corporate Bond ETFs

ETFtrends.com

As banks and institutions hoard fixed-income securities, investors have turned to bond exchange traded funds in response to the lack of liquidity across the underlying markets, potentially setting the stage for liquidity problems if ETFs experience large redemptions.

For instance, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has attracted $2.2 billion in new inflows year-to-date, Vanguard Intermediate-Term Corporate Bond ETF (VCIT) brought in $358.3 million, SPDR Barclays Intermediate Term Corporate Bond ETF (ITR) added $34.3 million and PIMCO Investment Grade Corporate Bond Index ETF (CORP) saw $99.4 million in inflows, according to ETF.com data.

Now, Barclays analysts led by Jeffrey Meli warned of a potential “fire sale” risk in ETFs and bond funds, notably those that track illiquid assets like corporate bonds, after large traders poured into bonds as rates fell and regulators forced financial institutions to obviate another 2008 crisis by holding more quality assets, reports Tracy Alloway for the Financial Times. [Rate Risk Raises Liquidity Concerns in Junk Bond ETFs]

“Regulations aimed at bolstering stability at the core of the financial system, combined with a growing demand for liquidity, may eventually lead to increased instability and fire-sale risk in the periphery,” Barclays analyst said.

As investors found it more difficult to price fixed-income securities, many have turned to ETFs for their greater perceived liquidity. For instance, LQD, with $21.9 billion in assets, has an average daily volume of 1.7 million shares. Taxable bond funds have attracted $1.2 trillion in inflows since 2009, and credit ETFs now make up 2.5% of the investment-grade corporate debt market.

“ETFs are being used not only by end investors looking for instruments with daily liquidity, but also by mutual funds seeking to mitigate the differences between the liquidity their investors expect versus the (poor) liquidity available in the underlying bonds,” Barclays added.

The potential problems ahead are associated with large redemptions in the ETFs or secondary markets. If enough people exit the funds, the ETF providers will have to swap shares for bond securities in the primary market. However, if there is not enough bond securities in the underlying market to meet redemptions, ETF investors may not be getting what they bargained for. [How ETFs Are Traded]

For more information on the fixed-income market, visit our bond ETFs category.

Max Chen contributed to this article.

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.