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 With bond market trading squeezed by central bank buying and tighter
regulation straining banks' market-making capabilities, ETFs --
baskets of securities that can be easily acquired on an exchange --
are thriving.
Provider BlackRock estimates assets in European fixed-income ETFs
have grown by 2.4 times since 2009 and that global fixed income ETF
assets may top $2 trillion by 2025. That would make them roughly the
same size as Italy's sovereign debt market.
Flows into European bond ETFs: http://reut.rs/1PAQqKp
The market is still in its infancy. Assets under management in ETFs
with exposure to European government and corporate bonds are worth
roughly 56 billion euros ($61 billion), up from about 26 billion
five years ago, according to Markit data.
"There has been a wave of flows into bond ETFs," said Lydia Vitalis,
who manages relationships with asset managers for Greenwich
Associates. "You have a lot of liquidity locked up in ETFs and
you're going to see ETFs having a growing influence on the market
place."
That influence comes with risks which some market watchers,
including the Bank for International Settlements, say are
contributing to a "liquidity illusion".
Liquidity, the ability to quickly execute large transactions at a
low cost and with a limited impact on prices, has become a major
concern in bond markets since central bank buying and regulation
have weighed on activity.
ETFs trade on stock exchanges and are popular with asset managers.
They combine liquid and less liquid assets, making it easier and
less risky to gain exposure to the latter.
But because ETFs tend to trade in line with cash bond markets they
could turn into a source of volatility if investors seek to exit
their positions simultaneously, especially in corporate debt.
Greater reluctance from banks to engage in market-making could
result in fewer willing buyers when the tide goes out, exacerbating
downward price moves.
"There is a problem of phantom liquidity," said Rabobank's head of
rate strategy, Richard McGuire.
Challenging liquidity conditions partly explain why ETFs have gained
favor with bond investors.
"Thinning bond market liquidity has helped drive institutional
demand for ETFs," said Brett Pybus, head of iShares EMEA fixed
income strategy at BlackRock. "The trading of individual bonds is
becoming harder, so we're increasingly seeing investors who focus on
this space starting to look at ETFs as another tool to complement
what they are doing," he said.
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A report last week from financial services data firm Greenwich
Associates said demand for bond ETFs is strong among institutional
investors in Europe, with six in 10 ETF investors using them to
access bond markets.
Vanguard, another big ETF provider, says ETF liquidity has little
impact on underlying bond market liquidity because buyers and
sellers on the exchange can offset each other's transactions.
SHIFT
Still, growth in ETFs marks a shift in the liquidity risk from banks
acting as market makers to asset managers, who may be better placed
to take it on.
"If a bank gets its risk model wrong, that can have wider
implications but even if the biggest bond ETF index in the world
suspended its redemptions that's not going to stop people getting
money out of a cash point," said David Amplett-Lewis, a portfolio
manager at investment firm Smith and Williamson.
However, he says, as ETFs' influence grows, their potential impact
on the market needs watching.
"ETFs are not inherently risk dangerous, but in an environment of
declining liquidity, as very large owners of bonds, ETF providers
need to be open about concentration where it exists, and cognizant
of the potential effects on orderly markets in the context of their
investors' expectations," said Amplett-Lewis.
(Graphic by Gustavo Cabrera Cervantes; Editing by Nigel Stephenson
and Toby Chopra)
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