Between the dramatic sell-off in German Bunds that unfolded over the course of three weeks beginning on April 21 and the erratic trading that ensued on Tuesday following the weakest JGB auction since 2009, the chickens, as they say, have come home to roost in government bond markets where thanks the ECB, the Fed, and the BoJ’s efforts to monetize anything that isn’t tied down, the market has become hopelessly thin.
As we’ve documented exhaustively — and as every pundit and Wall Street CEO is now suddenly screaming about — the secondary market for corporate credit faces a similar dearth of liquidity and at just the wrong time. Issuance is at record levels and money is pouring into IG and HY thanks to CB-induced herding (i.e. quest for yield) and record low borrowing costs (again courtesy of central planners), but thanks to the new regulatory regime which ostensibly aims to curtail systemic risk by cutting out prop trading, banks are no longer willing to warehouse corporate bonds (i.e. dealer inventories have collapsed), meaning that in a rout, investors will be selling into a thin market. The result will be a firesale.
So while policymakers are still willfully ignorant when it comes to honestly assessing the effect their actions are having on government bond markets, the entire financial universe seems to have recently become acutely aware of the potentially catastrophic conditions prevailing in corporate credit. These concerns have now officially moved beyond the realm of lip service and into the realm of disaster preparedness because as Reuters reports, some of the country’s largest ETF providers are arranging billion dollar credit lines that can be tapped to keep illiquidity from turning an ETF sell-off into a credit market meltdown:
The biggest providers of exchange-traded funds, which have been funneling billions of investor dollars into some little-traded corners of the bond market, are bolstering bank credit lines for cash to tap in the event of a market meltdown.
Vanguard Group, Guggenheim Investments and First Trust are among U.S. fund companies that have lined up new bank guarantees or expanded ones they already had, recent company filings show.
The measures come as the Federal Reserve and other U.S. regulators express concern about the ability of fund managers to withstand a wave of investor redemptions in the event of another financial crisis.
They have pointed particularly to fixed-income ETFs, which tend to track less liquid markets such as high yield corporate bonds or bank loans.
"You want to have measures in place in case there are high volumes of redemption so you can meet those redemptions without severely impacting the liquidity of the underlying securities," said Ryan Issakainen, exchange-traded fund strategist at First Trust…
Under the Wall Street reform act known as Dodd-Frank, banks have been shedding their bond inventories, resulting in less liquidity in fixed-income markets. Because there are fewer bonds available for trading, a huge selloff in the bond markets could worsen the effect of a liquidity mismatch in bond ETFs.
Vanguard, the second-largest U.S. ETF provider, lined up its first committed bank line of credit last year and now has a $2.89 billion facility backed by multiple banks and accessible to all of Vanguard's funds, covering some $3 trillion in assets, the Pennsylvania-based fund company told Reuters. The new setup is to "make sure that funds will be available in time of market stress when the banks themselves may have liquidity concerns," Vanguard said.
Essentially, ETF providers are worried that in a pinch (i.e. when ETF sellers outnumber ETF buyers), they will be forced to liquidate assets into structurally thin markets at fire sale prices in order to meet redemptions, triggering a collapse in the underlying securities (like HY bonds). In the pre-crisis days, this would have been mitigated by banks’ willingness to purchase what the ETF providers are looking to sell, but in the post-Dodd-Frank world this isn’t the case so the idea now is that bank credit lines will essentially allow the ETF providers to become their own dealers, meeting redemptions with borrowed cash while warehousing assets and praying waiting for a more opportune time to sell.
In case it isn’t clear enough from the above that ZIRP is in large part responsible for this, consider the following:
"These funds offer daily or even intraday liquidity to investors while holding assets that are hard to sell immediately, thus making the funds vulnerable to liquidity risk," U.S. Federal Reserve Vice Chair Stanley Fischer said in a speech in March in Germany, pointing directly to ETFs and saying they have mushroomed in size while tracking indexes of "relatively illiquid" assets.
That is all exacerbated because investors have been pouring money into bond ETFs, while banks, under regulatory pressure to limit their own holdings, have been slashing their bond inventories.
Growth in fixed-income ETFs also means there are now more products tied to corners of the bond market previously untapped by ETFs. Assets in U.S.-listed fixed-income ETFs are up nearly six-fold since 2008, to $335.7 billion at the end of April, according to Thomson Reuters Lipper data.
And why, one might ask, are investors suddenly interested in exploring “corners” of the bond market where they had previously never dared to tread thus creating demand for ever more esoteric ETF products? Because when risk-free assets are at best yielding an inflation-adjusted zero and at worst have a negative carry, investors are forced into credits they would have never considered before just so they can squeeze out some semblance of yield without simply dumping everything into equities.
Of course liquidity protection comes at a cost:
Banks facing their own reserve requirements against these lines are charging commitment fees that can range from 0.06 percent to 0.15 percent, according to company filings. If a line is actually drawn upon, there would be additional interest charged on any amount borrowed. In many cases, these costs are included in the ETF's annual expense ratio, and borne by the funds' investors.
In the final analysis, these liquidity lines are essentially distressed loans when drawn down, and the effect is to create yet another delay-and-pray ponzi scheme whereby liquidation is temporarily forestalled by borrowed money.