Fixed income myths, part 3: "Indexing and ETFs create liquidity issues in bond markets"
22 October 2020 | Portfolio construction
Commentary by Nusrath Hussain, senior ETF product specialist, and Kunal Mehta, senior investment product specialist.
A persistent myth in fixed income investing is that indexing and exchange-traded funds (ETFs) can cause severe liquidity issues in bond markets. At first glance, this might seem to make sense. After all, index-tracking funds enable investors to trade every day – or, in the case of ETFs, throughout the day – but large parts of the bond market don’t trade as frequently. So doesn’t that mismatch mean that index funds are inherently destabilising?
In a word: no. To start with, index funds make up only around 5% of the vast global bond market1. This makes it highly unlikely that their activities could cause problems for the market as a whole. Some of Vanguard’s fixed income mutual funds and ETFs have grown large enough to provide investors with the benefits of scale, but they are not nearly big enough to have a detrimental effect on the liquidity of the bond market.
We should remember, too, that fixed income liquidity is very different from that in the equity markets. The bond market dwarfs the equity market and is much less transparent. That’s because most fixed income trading does not take place through a central exchange but is conducted ‘over the counter’ between market participants.
Assessing bond market liquidity
Bond-market issuance also differs from its equity equivalent. Companies typically issue many different bonds, with differing maturities and yields. This contrasts with most equity stock-market listings, which involve a single class of publicly traded share. As a result, the bond markets are more opaque, and their liquidity is harder to measure.
This also means that bid/offer spreads in the bond market reflect a wider range of considerations than in the stock market. These include new issuance and bonds of differing maturities, in addition to the ability and willingness to buy and sell. The amount an investor is willing to pay for a bond is based on these factors and on the perceived risk of default and interest-rate movements. Ultimately, this means that different participants will make different assessments as to the value of any given bond. That too can make bond liquidity hard to assess.
The role of bond market index funds and ETFs
For investors buying for the long term, the importance of bonds is well documented. They can add value to a broad, diversified portfolio. Rather than invest in a broad range of individual bonds, however, it can be cheaper, quicker and more effective for investors seeking exposure to the bond market to buy an index-tracking fund or ETF instead.
Since index funds often represent entire markets or segments, some investors might be concerned about the potential negative implications, such as large transaction costs, if these fund have to hold every single security of the given market or segment.
However, in reality, managers of fixed income index funds often do not hold every single bond of the underlying index but build representative portfolios bond by bond – performing in-depth due diligence on each. Through this process, known as sampling, bond portfolios aim to replicate the risk and return profile of the index, ensure a certain level of liquidity and keep costs to a minimum.
Sampling isn’t a straightforward process. It requires experienced teams of specialists to evaluate the creditworthiness and relative value of bond issuers. But it allows an optimal trade-off between cost and replication. And it also helps to manage liquidity during periods of heightened volatility, because, in practice, it means that funds often have a higher concentration of sampling in more liquid securities. This can mean that performance temporarily diverges from the index, but managing liquidity in this way helps fund providers minimise transaction costs so investors are not penalised by selling less-liquid securities when redemptions do take place in volatile markets.
At Vanguard, our specialist teams continuously assess market conditions, buying and selling bonds to rebalance portfolios whenever necessary.
ETFs provide additional benefits to market participants
Next to index linked mutual funds, ETFs have grown in popularity over the years, not just in the equity market but also in the fixed income space2. ETFs differ from mutual funds largely because of the way investors transact in fund shares, and these differences provide ETFs with additional benefits in the form of secondary market liquidity. Secondary market transactions act as an additional source of liquidity. The following chart shows that an average of 63% of total fixed income ETF trading volumes take place in the secondary market.
Secondary market trading volumes as a percentage of total fixed income ETF trading volumes
Source: Bloomberg. Total trading volumes for top 50 (by assets) UCITS fixed income ETFs, 6 January 2020 to 14 August 2020.
Concern has been expressed about the role of authorised participants (APs) – the institutions that create or redeem additional ETF units. These are exchanged directly with the ETF issuer for baskets of the underlying bonds. Hence, APs come into play whenever an interaction with the primary market does happen. Some commentators have suggested that APs could refuse to redeem ETF units during periods of stress – leading to a lack of liquidity and a downward spiral in ETF share prices.
But APs are incentivised to avoid this. When ETF shares are trading at a discount to the value of the underlying assets, the APs can buy the shares and exchange them for a basket of those assets – which they can then sell at a profit. The wider the discount, the greater the opportunity for arbitrage.
This mechanism was tested in the extreme market conditions we saw in March. As the scale of the Covid-19 crisis became clearer, secondary-market trading in bond ETFs spiked, and discounts widened dramatically. This widening of spreads was a reflection of the underlying market conditions. But, rather than walking away, APs remained involved, enabling investors to keep trading intra-day in a way not possible via mutual funds. And as central banks have begun buying bonds, bid/offer spreads have tightened again.
Providing ready access to bond markets when liquidity is constrained
Ultimately, whether you’re buying a fixed income index fund or an ETF, investment-management expertise, product construction and the index methodology are the building blocks for a good product.
As we saw in March, index-tracking funds play an important role in giving investors ready access to the bond markets when liquidity might otherwise be constrained.
1 Source: Vanguard calculations, using data from Morningstar and FactSet, as at 31 December 2019. Global fixed income fund market share is represented by Morningstar global broad category group fixed income mutual funds and ETFs.
2 Source: ETFGI. The AUM of European-domiciled fixed income ETFs and ETPs (including both physical and synthetic products) rose from $142bn as at 31 August 2016 to $312bn as at 31 August 2020.
Bond index funds are often misunderstood and overlooked despite offering investors a logical diversifier to equity exposures. Learn some of the truths about bond index funds.
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