Bond ETF explosion fuels liquidity risks

Academic study finds high ETF ownership of corporate bonds can reduce investors' ability to 'diversify liquidity risk'

Tom Eckett

water splashing from a faucet

The rapid increase of assets in fixed income ETFs has led to an “unintended consequence” for investors in corporate bonds, according to a recent academic study.

The study, entitled Do Mutual Funds and ETFs Affect the Commonality in Liquidity of Corporate Bonds?, found rising corporate bond ownership in the ETF space is impacting the liquidity of the bond market.

In particular, it warned investment-grade bonds that are heavily owned by ETFs often share similar liquidity characteristics which could lead to suffering trading difficulties when exiting positions during periods of market stress.

The study, conducted by Efe Cotelioglu, PhD candidate at the Swiss Finance Institute, comes at a time when regulators are concerned that bond market fragility has increased.

For ETF critics, Cotelioglu’s study highlights what occurred during the coronavirus sell-off when bond ETFs widened to all-time high discounts before the Federal Reserve stepped in on 23 March.

“Higher ETF ownership of investment-grade corporate bonds can reduce the ability of investors to diversify liquidity risk,” Cotelioglu warned.

“From the viewpoint of a fixed-income portfolio manager, this may result in facing higher transaction costs and significant impact on bond returns, and even, not being able to trade during stress times.”

Assets in fixed income ETFs in Europe have exploded over the past 18 months with a record €54bn inflows in 2019 followed up by €27bn inflows so far this year, according to data from Morningstar.

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Furthermore, the research found mutual bond funds did have the same effect on liquidity as ETFs.

There were three reasons, Cotelioglu highlighted, as to why this was; the flow-driven correlated trading of ETFs, different investor clients and the ETF arbitrage mechanism.

“Mutual funds managers have discretion in responding to investor flows by buffering cash and trading securities selectively,” he continued. “However, ETFs essentially operate on autopilot by buying and selling bonds automatically to match an index, which may have unintended consequences on the underlying securities they hold.”


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