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pension recipients keeps rising, so has the need to keep assets which can be readily converted into cash if a scheme becomes cash-flow negative.
That is easier said than done. Some 78% of institutional investors report that it has become harder to trade bonds on primary mar- kets, according to Greenwich Associates. One reason is the height- ened capital reserve requirement that was introduced in the after- math of the financial crisis. They have made it more expensive for banks to operate as market makers.
In this context, passive funds focused on bonds have become a popular choice. At the end of January, global bond ETFs and exchange-traded products (ETPs) received net inflows of $21.1bn (£16.2bn), says data specialist ETFGI. This was a quarter of all net inflows gathered by ETFs and ETPs, although it was slightly down on the $23.6bn (£18.1bn) recorded 12 months earlier. 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 without a significant impact on the price of the ETF. Frank Mohr, head of ETF sales trading at Commerzbank, says that
despite engaging with institutional investors regularly, the process of creating and redeeming 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 pres- entation 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 second- ary market,” Mohr adds. “When we sell ETF shares, we simultane- ously go long in the underlying, say high yield emerging market debt, to balance our trading books. I then go back to the asset man- ager which delivers the underlying securities. There are no maxi- mum capacities for ETF share creation other than the maximum capacity of the underlying in the primary market.” But the main appeal for institutional investors is, of course, that by virtue of being traded on the secondary market it becomes much easier to sell an ETF. Investors buy and sell ETF shares through market makers and authorised participants (AP), rather than from the asset management company that 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 investing in collateralised debt obligations before the last recession. Stuart Trow, European Bank for Reconstruction and Development
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 sell- ing the ETF but the underlying bonds will still be traded on primary markets and other authorised participants might be step- ping 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 liquid than their underlying assets. Yet 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 how easy it is in reality. Stuart Trow, a credit strategist at the European Bank for Recon- struction and Development, says that institutional investors have been using ETFs as a cash proxy because they feel they can trade them at decent volumes. “But making the vehicle liquid doesn’t mean that the underlying is liquid. Some of the arguments for investing in ETFs sound a lot like the reasons for investing in col- lateralised debt obligations before the last recession,” he adds. “The problem with institutional investors treating such vehicles as readily realisable assets is that it is replicating some of the prob- lems that they have on the less liquid side of their portfolio rather than solving them. In the event of a crisis, ETFs might still be the first assets to be sold but investors might have to accept selling
24 March 2020 portfolio institutional roundtable: Fixed income
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