Bond liquidity has all but dried up for corporate issues after new
regulations and capital requirements forced Wall Street banks to
slash their inventories of fixed-income products following the
financial crisis. That's especially challenging for index fund
managers who must acquire certain bonds - or at least broad swaths
of bonds - to be able to track specific benchmarks.
The lack of liquidity also means funds may have trouble selling
bonds in the event interest rates rise and the investors who have
sunk about $1.2 trillion in net deposits into long-term bond funds
since the end of 2004 head for the exits.
Bonds inventory at Wall Street banks has dropped to about $60
billion from about $250 billion since the 2008 credit crisis,
according to the Federal Reserve Bank of New York, making them
harder to trade, analysts and fund managers said.
"The days where you can go out and say, 'I want these ten bonds' ...
and get the Street to offer them to you, are probably 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's more, 'what can I get and are those suitable substitutes for
what I actually want?'"
To combat the problem, Vanguard has relied on more fixed-income
trading specialists to hunt for hard-to-get bonds that are best
suited for building efficient index portfolios, Barrickman said.
Index funds have less latitude than actively managed funds, whose
managers are paid to beat benchmarks, not track them.
More corporate and municipal index funds are sampling the bonds
contained in their benchmark instead of trying to approach full
replication of the index. They also are going outside their
benchmark index to find substitutes for hard-to-get bonds, said
Steve Sachs, head of capital markets at ETF provider ProShares.
Sometimes the sampling can be extreme, producing returns that
severely lag their index.
The $30 million Market Vectors Pre-Funded Municipal ETF holds only
about 60 bonds, tracking a benchmark with more than 46,000 issues.
It offers a unique slice of the bond market of pre-funded municipal
bonds, but high transaction costs have produced a 12-month return
net of fees and expenses of 0.92 percent in the year ending Sept.
19, which is 23 basis points, or 20 percent, lower than the broad
benchmark’s return of 1.15 percent, according to Thomson Reuters
"There's plenty of room to find different names that satisfy our
need," said Jim Colby, manager of the Market Vectors fund, which is
operated by Van Eck Global in New York. "On the other hand, it makes
the process more complex to sort through the scenarios."
Even funds holding larger percentages of their index can find their
sampling cuts performance. The $617 million PowerShares Fundamental
High Yield Corporate ETF has 257 bonds in its portfolio, compared
with about 2,100 in its benchmark, and has lagged its benchmark by
as much as 1.40 percentage points for a 12-month period within the
past two years, according to ETF.com data. That's partly because it
weighs its sample more heavily to high-quality bonds, which limits
BlackRock Inc, the world's largest asset manager, says rock-bottom
interest rates and low volatility have created complacency among
issuers and investors, and that the market for trading corporate
bonds is broken.
"Driven by record new issue volume, the size of the market has grown
substantially while the market's trading capacity has decreased,"
BlackRock said last week in a research paper made public on Monday.
It's a perfect recipe for a bond market rout to whipsaw investors,
one fund index manager said.
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Meanwhile, many index bond funds are paying too much attention to
building portfolios that are easy to trade. That doesn't mean they
are doing an efficient job of tracking their benchmarks, said Dave
Nadig, chief investment officer at ETF research firm ETF.com.
State Street Global Advisors' $9 billion SPDR Barclays High Yield
Bond ETF gets high marks for having high yields and fees of 0.40
percent of assets invested, compared to 0.50 percent at a rival fund
run by BlackRock. But the fund's tracking error - the difference
between the return an investor receives and the benchmark's
performance - has been twice its fees at times, according to
As of June 30, the junk bond ETF's 12-month median tracking
difference was -0.72 percent, or six times higher than the -0.12
percentage points produced by BlackRock's $12 billion iShares iBoxx
$ High Yield Corporate Bond ETF, according to ETF.com.
"JNK has been sloppy in its tracking over the past two years, so
investors may find the all-in cost higher than advertised," ETF.com
said in a research report.
Brian Kinney, an executive at State Street Global Advisors, said
higher transaction costs due to the lack of liquidity on the bond
market contributed to the junk bond ETF's wider tracking difference.
Wall Street banks want to make more money per transaction because
regulators' new capital requirements have made holding bonds on
their balance sheets more expensive, Kinney said.
Even so, he said the State Street junk bond ETF tracks its benchmark
pretty tightly, given how volatile that sector can be.
To be sure, though some index funds select bonds that allow them to
outperform their indexes, it's more common for an index fund's
tracking difference to lag its index because of the cost of running
a fund that a benchmark doesn't have.
Nevertheless, index fund managers have always behaved a little like
political pollsters who sample a small group of people to get a
reading on a larger population.
Indexing giant Vanguard typically builds bond portfolios that come
closest to having the same number of holdings as their benchmarks,
fund disclosures show. The $121 billion Vanguard Total Bond Market
Index Fund holds 6,730 bonds, compared to nearly 8,900 in its
"I chuckle when people talk about a passive index bond fund," Nadig
said. "There's really no such thing. There ain't much passive about
it. These funds are constantly buying and selling."
(Reporting By Tim McLaughlin and Ashley Lau; Editing by Linda Stern
and John Pickering)
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