Corporate Bond ETFs and Liquidity: A Looming Black Swan or Extended Contango?

MarketsMuse update inspired by yesterday’s column by Tom Lydon/ and smacks at the heart of what certain “bomb throwers” believe could be a Black Swan event, albeit an event that may not be driven by a global crisis or surprise economic event. The event in question will, in theory, take place when interest rates start ticking up (and underlying corporate bond prices tick down) and institutional bond fund managers find themselves trying to figure out whether to simply suffer from mark-downs (and performance) or to continue collecting coupons until the issues they hold mature.

MM Editor Note: Since most folks know that bond managers are akin to lemmings (no disrespect intended!) and typically follow each other like blind mice, given the massive size of the corporate market place, a potential avalanche could take place when everyone runs for the exit if rates tick up and simultaneously, the economy starts to slow. Wall Street dealers are certainly not going to be available to catch those falling knives, simply because new regulations have put a crimp in the capital they can commit to warehousing positions. Worse still, its easy to envision one very long contango event, where the cash ETF trades at a discount to the value of the underlying bonds, simply because one won’t be able to sell those underlying bonds in any type of material size.

Here’s an opening extract from Tom Lydon’s piece “Liquidity Concerns In Corporate Bond ETFs”:

Tom Lydon,
Tom Lydon,

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

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