Last month we learned that some of the country’s largest fund managers (including Vanguard) have been busy lining up billions in emergency liquidity lines with banks to protect them in the event rising rates, shale defaults, or some unexpected exogenous shock leads to a sudden exodus from the high yield and other more esoteric ETFs that have become popular among today’s yield-starved investors.
Essentially, these liquidity lines would allow fund managers to cash out investors with borrowed money, while holding onto the underlying assets rather than selling into an illiquid secondary market where dealers are no longer willing to hold inventory, and where a wave of liquidations could become self-fulfilling.
The problem with this strategy is that it’s yet another example of delaying the inevitable. That is, if fund managers are forced to tap these liquidity lines it likely means investors have found a reason to sell en masse and if that reason turns out to be something that permanently impairs the value of the underlying bonds (as opposed to a transitory, irrational panic) then all they’re doing by borrowing to meet redemptions is employing leverage to stave off the recognition of losses, which is ironically the same thing (in principle anyway) that the companies whose bonds they’re holding have done to stay in business. It’s a delay-and-pray scheme designed to avoid selling the debt of companies whose similar delay-and-pray schemes have run their course.
All of this comes back to underlying liquidity. The reason all of the above is necessary is because fund managers are afraid that when they go to sell the assets behind their funds, the secondary market will be so illiquid that trading in size will have an exaggerated effect on prices which could then trigger more retail fund outflows, forcing more managers to sell into an illiquid market, and so on and so forth until a sell-off becomes a firesale and a firesale becomes an all out panic.
This wasn't the case in the pre-crisis world and as Barclays notes, fund managers are now using ETFs as a substitute for liquidity that would have previously been provided by dealer inventories. As you'll see below, this works as long as gross flows are appreciably different from net flows, but when the two begin to converge (i.e. when it's a one-way rush to the exits), trading the underlying assets and thus venturing into what is now a very thin secondary market for corporate bonds becomes unavoidable, which is precisely why ETF providers are arranging for liquidity lines — it's an attempt to forestall the inevitable.
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Using ETFs To Mitigate Fund Flows
As asset managers continue to struggle to manage portfolios amid low corporate bond liquidity, we have seen a surge in the use of portfolio products, such as ETFs, CDX, and TRS on corporate bond indices. While some of these products – notably ETFs – are often lumped in with open-end mutual funds as a potential source of trouble in the event of concentrated retail selling, they are also being used by fund managers to mitigate the problems posed by poor liquidity. This raises the natural question: how much can portfolio products offset the decline in liquidity? Or, more colloquially: are ETFs good or bad for corporate bond liquidity?
Although fund flows have been a major focus of market participants over the past several years, the aggregate flows attract the most attention. This is particularly true in the high yield market, where retail ownership is relatively high and the price swings associated with contemporaneous fund flows have been well documented. Aggregate flows have effectively become a market signal.
From the perspective of an individual fund manager, the risk posed by fund flows and the strategies available to help mitigate that risk depend to a large extent on the correlation of flows across funds. If flows are highly correlated – i.e., if every fund experiences inflows at the same time – then the risk is relatively high. Funds will have a difficult time selling bonds when they experience an outflow, since other managers would similarly be selling. In this circumstance, managers have a relatively short list of strategies to deal with flows. They can keep increased cash on hand, or (less likely) they can hope that other non-retail buyers step into the market at a reasonable discount to market levels.
On the other hand, if flows are relatively uncorrelated they may, in principle, pose less of a risk – funds with outflows can sell to those with inflows. Funds can exchange bonds (or portfolio products, see below) with other funds, rather than draw down on or build cash. This process may be made more difficult by the decline in liquidity, but the price discount/premium faced by an individual fund with an inflow or outflow could, theoretically, be limited by the existence of investors looking to go in the opposite direction.
Portfolio Products Replace Dealer Inventory
While diversifiable flows limit the risks to portfolio managers in principle, the reality of the high yield market is more complicated. Managers have specific views on tenor, callability, sectors, covenants, and, most importantly, individual credits, such that actually finding buyers for specific bonds can be quite difficult. In the pre-crisis period, dealers ran large inventories that effectively facilitated the netting of flows across funds (Figure 1). A fund with an outflow would sell bonds into the dealer community, and funds with outflows would buy bonds out of the dealer inventory. When inventory is large, the fact that the specific bonds bought and sold did not match was largely irrelevant. Funds with outflows could sell the bonds of their choice, and the funds with inflows could pick investments from the large variety of inventory held by dealers.
The matching problem has become more acute as dealer inventories have declined. Even funds can net flows in principle, dealers are much less willing to warehouse bonds, and are much more likely to buy only when they believe they can quickly offload the risk. Under this scenario, the fact that flows can theoretically be netted is of little practical use to fund managers – actually netting individual bonds is extremely difficult, particularly in the short time frame required by funds offering daily liquidity to end investors.
This is where portfolio products come in. Investors can use portfolio products to fund outflows/invest inflows immediately and execute the necessary single-name bond trades over time as liquidity in the underlying bond market allows (Figure 2). In this scenario, funds with inflows and outflows simply exchange portfolio products, sidestepping (the immediate need to trade single-name corporate bonds.
To assess the extent to which flows are diversifiable across funds, we examine about two years of weekly flows at the individual fund level. We have data from Lipper on the flows of more than 800 dedicated high yield mutual funds. We separate the funds into those with inflows and those with outflows for the week, and sum the aggregate inflows and outflows..
The total volume of high yield ETFs has grown nearly seven-fold since 2009 (Figure 8). While the “net” portion of the volume must be satisfied by share creation or destruction (which leads to buying or selling of underlying corporate bonds), the remaining share captures risk transfer that takes place without tapping into the corporate bond market Figure 9 shows that the “net” portion of the volume was only 12% in 2014 and has declined meaningfully over the past few years. This suggests that ETFs are additive to liquidity,allowing mutual funds to manage daily liquidity requirements while circumventing the underlying bond markets where liquidity remains poor.
While portfolio products are clearly a useful tool for liquidity management, their use can exacerbate the problem they are meant to solve. Said another way, choosing to trade liquid portfolio products to avoid trading less liquid bonds makes the latter even harder to trade.
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To summarize, fund managers are concerned primarily about the direction of flows into and out of their own funds versus the direction of flows into and out of other funds. Outflows from one fund can be matched with inflows to another, and ETFs can facilitate this, allowing managers to avoid tapping what is an increasingly illiquid corporate bond market. The fact that net flows (i.e. those that must be settled by buying or selling actual bonds) have declined as a percentage of gross volume amid the proliferation of bond ETFs suggests that ETFs have had a positive effect on liquidity. But there's a problem with this logic.
This only works when net flows are lower than gross flows. If the two converge in a sell-off (i.e. when trading becomes unidirectional) the underlying assets must necessarily be sold as there are no inflows to net against a wave of outflows.
In other words, if I'm a fund manager, the idea that ETFs provide liquidity rests on the assumption that when I experience outflows, someone else will be experiencing inflows and thus I can sell ETFs and avoid offloading my bonds into an illiquid corporate credit market. Put another way: I am depending on new money coming into the market to fund redemptions from previous investors who are exiting the market, all so that I can avoid liquidating assets that are declining in value and that I believe will be difficult to sell. There's a term for that kind of business. It's called a ponzi scheme and just like all other ponzi schemes, when the new money dries up (so, for example, when HY bond ETF flows are all headed in the wrong direction), the only way to meet redemptions is to get what I can for the assets I have and when the market for those assets is thin (as the secondary market for corporate credit most certainly is), I may incur substantial losses.
Note also that the more often ETFs are used as a way of avoiding the underlying bond market, the more illiquid that market becomes, making the situation still more precarious in the event of a panic.
As we said last month, this is why fund managers are arranging emergency liquidity lines and on that point, we'll close by saying that no fund manager in the world will be able to line up enough emergency liquidity protection to avoid tapping the corporate credit market in the event of panic selling in the increasingly crowded market for bond funds.