Credit ETFs Cause a Liquidity Problem and Then Sell the Solution

(Bloomberg) -- Wall Street’s long-running debate over whether corporate bond ETFs are either a force for good or bad might be missing the point. Both sides are likely right.

As U.S. exchange-traded credit funds hit about $270 billion in assets, Barclays Plc research shows the passive boom is coming at the expense of liquidity in the underlying market overall -- increasing transaction costs along the way.

But at the same time, ETFs provide a solution to the very problem they’re helping to cause by making trading easier and cheaper in the specific securities they track, particularly in the world of high yield.

Put another way, these investing products are hoovering up many of the flows that otherwise would go directly into the cash market. And that makes them increasingly the only liquidity game in town.

“Investors who do not adapt to use new liquidity management tools and techniques could be made worse off as the liquidity available via traditional channels declines,” Jeffrey Meli, Shobhit Gupta and Zornitsa Todorova wrote in a research note last week. “ETFs themselves are so liquid that the overall transaction costs paid by investors are lower, so long as they use ETFs to manage liquidity.”

That’s a call institutional investors are already heeding in droves. Alongside the boom in fixed-income products, there’s been a surge in the use of portfolio trades, which usually take advantage of the ETF structure to move large packages of bonds in one go.

Liquidity Drop

The Barclays analysts crunched data across the Bloomberg Barclays Investment Grade Corporate Bond Index and the Bloomberg Barclays High Yield Corporate Bond Index over seven years through December 2019.

They found ETFs cut the cost of trading junk bonds in particular. Over the period, transaction costs for securities added to the $24 billion iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) fell by 14.4 basis points, or 14%.

A similar effect took place in investment grade too, albeit smaller: Costs dropped by 3.5% on securities included in the $54 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

The liquidity boost from being added to an ETF is likely a byproduct of the create-and-redeem process, in which market makers and issuers exchange baskets of the underlying bonds for the fund’s shares.

Not every trade results in creation or redemption, but fixed-income ETFs are much more liquid than their holdings so the process can spur trading in a security that otherwise might not change hands for days or months.

This added activity has to come from somewhere, which is where an overall drop in liquidity in the cash market is showing up.

The use of ETFs “naturally comes at the expense of corporate bond trades that otherwise would have happened,” the strategists wrote. “Non-ETF bonds have sharply lower liquidity as a result of the migration of trading into ETFs.”

Inevitably if they’re harder to trade, the cost of doing so rises. Transaction costs for bonds not in ETFs climbed by 8% in high yield during the period and 2% in investment grade, Barclays found.

Doom Loop

The Barclays analysis put numbers the do-or-die investing tool. It finds that investors need to trade only between 4.8% and 5.6% of their total volume in ETFs to offset the increased costs caused by passive products undercutting liquidity for securities excluded from the wrapper.

Meanwhile, the team notes that the benefits of ETFs hold in both high- and low-volatility periods, so the research should go some way to easing fears of an illiquidity doom loop in stressed markets as investors rush for the exits.

Read more: Fixed-Income ETFs Survived Their First Crisis—Helped by the Fed

“Were this the end of the story, the introduction of bond ETFs would be a clear benefit to investors,” the strategists wrote. “However, the effect of ETFs on HY bond liquidity in particular is more complex than this simple comparison suggests.”