In the interest of not burying the lead, so to speak, we'll begin with a clip from this week's Delivering Alpha conference.
In it, Carl Icahn essentially rehashes everything we've said over the past several months about the systemic risk posed by phantom ETF liquidity. He then proceeds to explain to Larry Fink how BlackRock is a part of the problem, calling the firm "a dangerous company", before opining that Fink and Janet Yellen are "pushing the damn thing off a cliff." Needless to say, Fink did not agree with Icahn's assessment. Here are the fireworks:
For those interested to know more, below is the complete Zero Hegde guide to phantom ETF liquidity and a discussion of how it has set the stage for a bond market meltdown.
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Two months ago, in “ETF Issuers Quietly Prepare For Meltdown With Billions In Emergency Liquidity,” we outlined the rather disconcerting circumstances that have led some large fund managers to quietly line up emergency liquidity facilities that can be tapped in the event of a sudden retail exodus from bond funds.
"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," Reuters reported at the time, in a story we suspect did not get the attention it deserved.
At a base level, these precautionary measures are the result of the interplay between central bank policy and the unintended consequences of the post-crisis regulatory regime. ZIRP creates a hunt a for yield and simultaneously incentivizes companies (especially cash strapped companies) to tap the bond market while borrowing costs remain artificially suppressed. Clearly, this is a self-fulfilling prophecy. The longer rates on risk free assets remain near, at, or even below zero, the more demand there is for new corporate issuance (the rationale being that at least corporate credit offers some semblance of yield). More demand means rates on corporate credit are driven still lower, and once yields on high grade issues get close to the lower limit, yield-starved investors are then herded into HY.
All of this supply in the primary market comes at a time when liquidity in the secondary market for corporate credit is non-existent thanks to the shrinking dealer books that resulted from the government’s (maybe) well-meaning attempt to crack down on prop trading. The result: a crowded theatre with a tiny exit.
This situation has been exacerbated by the proliferation of bond ETFs which have allowed retail investors to pile into corners of the fixed income world where they might not belong.
All of the above can be summarized as follows.
"MF assets too large versus dealer inventories" (via Citi)...
... clear evidence of "structural damage in corporate bond trading liquidity" (via JP Morgan)...
... and the rapid growth of bond funds in the post-crisis world (via BIS)...
So given the above, the question is this: if something were to spook the market - a rate hike cycle for instance, or an October revolver raid on HY energy names, or an exogenous geopolitical shock - causing an exodus from these funds, what would happen to prices if fund managers were suddenly forced to transact in size in an illiquid secondary market in order to meet redemptions?
"Nothing good", is the answer.
The solution is to avoid selling the underlying bonds - even when investors are selling their shares in the funds.
But how is this possible?
To a certain extent, outflows in one fund can be offset by inflows to another. These "diversifiable flows" are one happy byproduct of the great ETF proliferation. Here's a refresher on how this works courtesy of Barclays.
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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.
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Ok great, so ETFs provide a kind of "phantom" liquidity if you will. There are two problems with this:
- It only works when flows are diversifiable. Once flows become unidirectional, it all goes out the window.
- It makes the underlying markets even more illiquid.
Here's how we put it last month in "How Fund Managers Use ETF Phantom Liquidity To Avert A Meltdown":
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.
So what is a fund manager to do?
This is where we come full circle to the emergency liquidity lines mentioned at the outset. In order to avoid tapping the underlying illiquid bond market in a situation where flows are unidirectional, fund managers may instead pay out redemptions in borrowed cash.
This is, to quote Citi's Matt King, "creative destruction destroyed."
That is, this represents the willful delay of a long overdue episode of creative destruction layered atop another delay of the much needed Schumpeterian endgame. Stripping out the metaphysics and philosophy references, that can be translated as follows: this strategy is yet another example of delaying the inevitable. 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 the funds are 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.
In closing, it's important to note 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.
In other words, when the exodus comes, the illiquidity that's been chasing markets for the better part of seven years will finally catch up, and at that point, all bets are officially off.