Feature | Fixed income


ETFs as a cash proxy, but can such vehicles offer additional liquidity when volatility spikes?


BOND MARKET DRAUGHT Times are undoubtedly challenging


for


bond market investors. After more than a decade of loose monetary policy, a quarter of the world’s bonds, amounting to more than $14trn (£11.48trn), are now trading at negative rates. Over the summer, the US yield curve slipped into inversion with the yield on 10-year US treasuries falling below that of two-year bonds as investors piled into long-term high-grade debt for safety. Yet for many institutional investors, defined benefit (DB) schemes in particular, holding illiquid assets alone is simply not an option. The majority of final salary schemes in the UK are closed to further accrual and as the share of pension recipients is rising, so has the need to keep assets which can be readily converted into cash.


That is easier said than done. Some 78% of


£250bn in 2018, up from £11bn 10 years ear- lier, the Investment Association says. The industry body also claims that institutional investors have jumped in on the hype with about a third of pension fund assets being invested passively. The appeal of passives lies in their unique structure as a hybrid between open and closed-ended funds and being traded as shares. However, this feature could also be the root concern around liquidity. The benefits of investing in bond ETFs are clear. Being traded daily, fund providers disclose their holdings at the end of each day, offering increased transparency. Moreover, because ETFs are traded as shares, supply is much more flexible than the availability of the underlying assets, making it possible for large institutional investors to execute large scale orders with- out a significant impact on the price of the ETF. Frank Mohr, head of ETF sales trading at Commerzbank, says that despite engaging


our trading books. I then go back to the asset manager which delivers the underly- ing securities. There are no maximum capacities for ETF share creation other than the maximum capacity of the underlying in the primary market.” But the main appeal for institutional inves- tors is of course the fact that by virtue of being traded on the secondary market, it becomes much easier to sell an ETF. Inves- tors buy and sell ETF shares through mar- ket makers and authorised participants (AP), rather than from the asset manage- ment company which issued them. While APs and market makers have no obligation to buy shares, other market makers might step in because they identified an arbitrage opportunity.


Some of the arguments for investing in


ETFs sound a lot like the reasons for invest- ing in collateralised debt obligations before the last recession. Stuart Trow, European Bank for Reconstruction and Development


institutional investors report that it has become harder to trade bonds on primary markets, according to Greenwich Associ- ates. One reason is the heightened capital reserve requirement that was introduced in the aftermath of the financial crisis. They have made it more expensive for banks to operate as market makers. In this context, bond ETFs have become a popular choice. As of July, assets invested in European ETFs and exchange-traded products (ETPs) reached a record $910.3bn (£748.9bn), while US ETFs hit the $4trn (£3.29trn) milestone, according to data spe- cialist ETFGI. In the UK alone, assets invested in UK-listed ETFs spiked to


with institutional investors on a regular basis, the process of creating and redeem- ing ETF shares remains obscure, even to seasoned investors. “One of my slides explains the basic creation and redemption mechanism and even after having given this presentation for eight years I still feel that it is necessary. “As authorised participants we are entering contracts with the asset management firm, which authorises us to issue and redeem ETF shares which are then sold to the end investors in the secondary market,” Mohr adds. “When we sell ETF shares, we simul- taneously go long in the underlying, say high yield emerging market debt to balance


36 | portfolio institutional | September 2019 | issue 86


This buffer function of ETFs also extends to primary markets. “In the event of a crash,” Mohr says,” the ETF could have a certain absorber function in the sense that the end investor might be selling the ETF but the underlying bonds will still be traded on pri- mary markets and other authorised partici- pants might be stepping in because spreads are widening again.” Yet it could be questioned whether these benefits also uphold in the event of a bond market crash, or as Warren Buffet once famously put it: “Only when the tide goes out do you discover who’s been swimming naked.” Investors have been buying ETFs on the premise that the funds are more liq- uid than their underlying. But financial market regulators have expressed concern about the inherent “liquidity mismatch” which describes the gap between investors belief of how easily they can turn their assets into cash and the ease in reality. Stuart Trow,


credit strategist at the


European Bank for Reconstruction and Development, says that institutional inves- tors have been using ETFs as a cash proxy because they feel they can trade them at decent volumes. “But just by making the vehicle liquid doesn’t mean that the under- lying is liquid. Some of the arguments for investing in ETFs sound a lot like the rea- sons for investing in collateralised debt obligations before the last recession,” he adds.


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