Over the weekend we shifted our focus from the inverse volatility ETF complex and to credit ETFs, both IG (LQD) and HY (HYG and JNK), highlighting that at least according to Deutsche Bank, these have a decent chance of being the next synthetic products to suffer sharp deterioration following the next market tremor.
What Deutsche Bank found was that in light of the sharp move in the VIX, credit ETFs had shown a surprising resilience, which however would be tested if the VIX does not mean-revert from its current level around 20 back to its all-time "complacency lows." Addressing this, Deutsche said that "if credit spreads do indeed reprice to higher volatility, the drawdown in credit ETFs could trigger meaningful liquidation, resulting in further pressure on spreads." It then empirically calculated the adverse impact, if only in theory:
To attempt to put some numbers around it, empirically a 1% m/m selloff in IG ETFs is consistent with a 1.9% decline in IG ETF AUM (currently about $130bn), meaning a 0.9% liquidation; for HY ETFS, a 1% sell-off equates to a 2.8% drop in ETF AUM (currently about $45bn), and therefore a liquidation worth 1.8% of AUM.
It gets worse: assuming the full repricing implied by the move higher in volatility occurs, it would result in a $3.7bn redemption in IG funds, and about $6bn in HY ETFs (and the longer that VIX remains elevated, the more this risk grows). The acute risk for the credit market should such a flow materialize should be for HY, conditional on how concentrated it is – average daily volume in IG was about $17bn last year, whereas for HY is was $7.7bn.
DB's conclusion: "Should credit sell-off to where the current level of volatility implies, liquidity would likely deteriorate anyway, and the added pressure from fund outflows would likely further exacerbate the spread widening."
To this our response was to "follow the money" and specifically, the flows in, or rather out, of the bond ETF complex.
Today, Bank of America also takes a close look at recent ETF flows and finds two opposing trends, split between equities and debt.
First the good news: last week - during which the S&P 500 rebounded 4.3% (biggest weekly gain since Jan. 2013) - BofA's clients were big net buyers of equities ($1.35bn) for the second week after near-record selling at the end of January (when the market hit its all time high). Here, clients bought both single stocks and ETFs (second week of single stock buying). While private client (i.e. high net worth retail investors) have led the buying over the last two weeks, institutional clients were also buyers for first time in 16 weeks, after having been the biggest sellers during the pullback. Meahwhile, the 3rd client group, hedge funds were sellers after buying equities the prior week. Clients bought large and small caps but sold mid caps. Meanwhile, corporate buybacks are tracking above typical Feb. levels as well as above year-ago levels. BofA notes that financials continue to dominate buyback activity, comprising 42% of total corporate client buybacks year-to-date (up from 38% last year).
To summarize equity flows (on a rolling 4 week basis):
- Hedge funds have been net sellers of US stocks on a 4-week average since late Jan. 2018.
- Institutional clients have been net sellers on a 4-week average basis since early Feb 2016.
- Private clients have been net buyers of US equities on a 4-week average basis since early Feb. 2018.
Now the bad news: while clients bought equity ETFs for the first time since the selloff began, BofA adds that "they sold fixed income ETFs for the third week, the longest selling streak since we began tracking ETF granularity in 2017 (driven by institutional and hedge fund clients)".
This rising bond ETF selling begs the question: is it the result of concerns about a potential return of market volatility, or due to simply rising rates. If it is the latter, and if the selling continues - or accelerates - the reverse feedback loop from bonds to stocks will likely hit next, and what's worse, should the weakness in equities observed earlier this month finally hit bonds, this time the volocaust will be far worse as it will originate not in equities, or rather inverse VIX ETFs, but the nexus of risk itself: synthetic credit instruments, a not so subtle repeat of what catalyzed the events of 2008.