Do Bond ETFs Pose A Systematic Risk? Regulators Confused, Investors Confounded

Index fund managers are finding it challenging to ensure the bonds they need in the prices they want, driving them to make trade-offs that leave supervisors vulnerable in a market downturn and may hurt investors.

Bond liquidity has all but dried up for corporate problems after new regulations and capital requirements compelled Wall Street banks to slash their stocks of fixed income products following the fiscal disaster. That’s especially challenging for index fund supervisors who must get certain bonds to be able to monitor specific standards.

The lack of liquidity additionally means funds could have trouble selling bonds in the event interest rates rise and also the investors who have sunk about $1.2-trillion (U.S.) in net deposits into long-term bond funds since the end of 2004 head for the exits. The Financial Stability Board (FSB) is analyzing whether exchange-traded funds pose a hazard to the global financial system for exactly that reason, in accordance with the Bank of Canada’s representative to the committee.

“There’s been investments and positions taken that may not possess the liquidity there that people expect, especially as interest rates begin to normalize,” Carolyn Wilkins, senior deputy governor at Canada’s central bank, told Bloomberg News in an interview. “So the liquidity illusion, should you prefer to put it that way, is something which we’re worried about.”
The Basel-based FSB, which includes regulators and central bankers from round the world, discussed at meeting last week whether ETFs predicated on assets that commerce in less-fluid markets would have the capability to market their holdings and honour all their obligations within a big withdrawal, Ms. Wilkins said.

“They look right now which they have the liquidity of an equity, but they possess the diversification of some other kind of asset,” she said. “The thing about them is the underlying assets can sometimes be very illiquid. What is uncertain is whether these ETFs in a time of stress, really possess the liquidity that is there.”Some ETFs being analyzed may comprise high-yield bonds, Carolyn said.

Bond inventories at Wall Street banks has dropped to about $60-billion from about $250- billion in accordance with the Federal Reserve Bank of New York, making them more difficult to trade, analysts and fund managers said.

“The days where you could venture out as well as say, ‘I desire these 10 bonds’ … and get the Street to offer them to you, are likely gone,” said Josh Barrickman, head of bond indexing at Vanguard Group Inc., which oversees $325-billion in index bond fund and ETF assets. “So now it is more, ‘What may i get and are those acceptable replacements for what I actually desire?'”

Index funds that are more corporate and municipal are sampling the bonds comprised in their standard instead of attempting to approach full replication of the index. They also are going outside their standard index to find replacements for hard-to-get bonds, said Steve Sachs, head of capital markets at ETF provider ProShares.

It’s a great recipe to get a bond market rout to whipsaw investors, one fund index manager said.

Meanwhile, many index funds are paying a lot of attention to building portfolios that are not hard to trade and carrying out a poor job of tracking their benchmarks, said Dave Nadig, chief investment officer at ETF research firm
State Street Global Advisors’ $9-billion SPDR Barclays High Yield Bond ETF charges a fee of 0.4 per cent of assets invested, compared to 0.5 per cent at a competing fund run by BlackRock. However, the fund’s tracking error – the difference between the yield an investor receives and the benchmark’s performance – has been twice its fees at times, according to