It is no secret that liquidity in the bond markets has been steadily declining in the past few years. Banks are retreating from making markets due to regulatory constraints, while the large issuance in corporate bonds, global monetary policies and the growth in bond exchange-traded funds are also taking their toll.
This sea change in the largest securities market globally - it's estimated to be in excess of $100trn - is no surprise. After all, it remains one of the most opaque markets in an increasingly transparent world. There is no central exchange where bonds go to be traded and the sheer number of bonds is vast. Often, for every one share there can be multiple bonds. This means that while some bonds are traded regularly, there are others that can go months without being traded.
The advent of ETFs has given investors an easier, cheaper and more direct route to the bond market. Bond ETF assets now sit at $750bn, or roughly 18% of global ETF assets and by 2022 they are expected to hit $150trn, according to data from BlackRock.
But it is this explosive growth at the same time as tightening regulations, lack of visibility and decreasing liquidity in the underlying market that makes me nervous.
And I'm not alone. Hedge fund managers also have reservations about bond ETFs - in March 2015 Oaktree Capital's Howard Marks asked of bond ETFs in an open letter to Zero Hedge: "do the investors in ETFs wonder about the source of their liquidity?"
Bond ETFs haven't had any real tests yet - 2013 was the closest things got to getting a bit hot under the collar. It saw a wave of selling in the bond market that caused many ETFs to fall below the value of their underlying assets as spreads widened. At the time Citigroup stopped accepting orders to redeem underlying assets from ETF issuers as it had reached its risk limits - they'd saturated their collateral quota. Similarly, State Street stopped accepting cash redemption orders for municipal bond products from dealers. Redemptions in kind continued.
The results of the bond sell-off pointed to liquidity issues.
Liquidity in ETFs is in two parts; primary and secondary. Secondary liquidity is what you see on screen - trading is then done with other investors or market makers with shares that already exist. Primary liquidity is how easy it is to create or redeem ETF shares - it hinges on how liquid the underlying securities that an ETF holds are, enabling the authorised participant to create or redeem shares.
When liquidity dries up in the bond market the spreads widen and the concern is that the gap between the value of the ETF and the underlying will get too big. This happens because in stressed markets it's hard to sell bonds and liquidity dries up when the dealers stop trading.
And it's a fair concern right now. In July this year the Federal Reserve said that post financial crisis rules may constrict bond dealers' incentives to make markets. "A series of changes, including regulatory reforms, since the global financial crisis have likely altered financial institutions' incentives to provide liquidity."
The FCA also showed that liquidity in the corporate bond market has been declining since the middle of 2014, in research it released earlier this year. The report looked at the standard measures of liquidity and dealers' ease of trading. It concluded that some dealers are pulling back from providing market making services "due to a combination of strategic, capital and regulatory factors."
So my question is if a mass sell-off occurs (e.g. if interest rates rise) then how will bond ETFs fair? Can APs continue to create and redeem shares? It will probably depend on the bond. Huge, liquid bonds such as SLSX and IEML will probably come out of it fairly unscathed. But for smaller illiquid bonds - high yield and municipal bonds - it's unclear.
The good news is that the regulators are starting to get on board with making the bond market more transparent. The Trade Reporting and Compliance Engine (TRACE) was introduced in 2002 in the US - it requires that all corporate bond trades, including private placements and CBs, to be reported within 15 minutes.
Volumes reported through TRACE have expanded rapidly and thousands are now reported every day. The data in TRACE is now extensive and can be used for credit monitoring, estimating inventory, trading and transaction cost analysis.
Some trading platforms are also helping by cutting out dealers and using peer-to-peer platforms to trade. Regulators are also encouraging peer-to-peer exchanges where bond sellers can access each other and not go through a dealer.
Mifid II is also likely to help boost transparency with its trade reporting requirements; a move that has spurred mixed results. Some market participants are concerned it will inhibit liquidity while others think it will spur on liquidity giving market participants more confidence