Fixed income ETFs have hit $1 trillion globally—and with success comes critics. There’s a narrative that fixed income ETFs are taking on too much market share, haven’t been tested, and that they could be a harbinger of doom if a crisis hits, as “you are providing daily liquidity to an illiquid asset class.” I argue below why this narrative is nonsense.
Say not tested again—I dare you, I double dare you
Fixed Income ETFs haven’t been tested? Well, like Jules Winnfield from Pulp Fiction, allow me to retort. ETFs have absolutely been tested throughout their tenure. Brexit is a perfect example. Or the fact that Global Economic Policy Uncertainty reached four new all-time highs in the past five years.1 Not to mention that three of the top 10 highest readings for a gauge of macro risk from Citi2 came in the past five years, with one instance in 2014 eclipsing the highest reading from the global financial crisis in 2008.
I’ll concede that since the 2008 financial crisis, we’ve been in the longest economic expansion in history, so fixed income ETFs haven’t been truly equity bear market-tested. But let me respectfully Dikembe Mutombo that assertion with the Ship of Theseus paradox. (I know, a sports and philosophy reference in the same sentence, but stay with me.)
The fact is, fixed income ETFs have gone through numerous market events unscathed, without being forced to liquidate or gate redemptions. (By the way, mutual funds weren’t so lucky during some of these events3). In each instance, the ETF continued to offer investors the ability to express market views in real-time with efficiency, flexibility, and liquidity. For instance:
- The 2011 US Sovereign Debt Downgrade fiasco came when fixed income ETFs were just starting to really gain acceptance—even though they had been around since 2002.
- The 2013 Taper Tantrum had yields on mortgage-backed securities increasing by 50% in the span of six months, given that 10-year interest rates spiked 87% over the same time period.
- The 2015 energy crisis had both investment grade and high yield credit spreads widening out to post-recession highs as defaults and downgrades piled up.
- The 2016 Trump Bump, when 10-year interest rates shot up nearly 50% in the span of one month, roiling emerging market debt with a 7% plunge over the same time period.
- The 2018 double whammy of volatility events (February, Q4) where high yield ETFs ultimately lost 20% of their assets during the year. Yet, the market continued to function—and even rebounded in 2019, with high yield ETFs taking in 30% of their start-of-year assets through July 22.4
But what about that tricky liquidity to illiquid assets question?
While the trope of “you are providing daily liquidity to an illiquid asset class” is catchy, it’s often misguided. Fixed income ETFs do provide investors with daily liquidity to an asset class where the underlying securities do not always trade on a regular day-to-day basis. But so do mutual funds. The real question comes down to which vehicle offers superior liquidity that can be tapped into during periods of economic or market stress.
Fixed income ETFs provide two layers of liquidity (secondary and primary market) to mutual funds’ single-only layer (primary). The presence of a liquid secondary market offers price transparency and the ability to liquidate positions without touching the primary market. This is visible with the secondary-to-primary market ratio—a gauge of the amount of activity in the secondary market that flows down into the primary market.
For instance, a ratio of 5:1 means that for every $5 traded on the secondary market, only $1 flows through into the primary market. This dynamic negates the view of providing liquidity to an illiquid asset class, as not all transactions actually touch the asset class.
Now, mutual funds can only be redeemed at the market close, when the fund manager would have to trade into the primary market to raise enough capital to fulfill any redemption requests. Therefore, it is fair to conclude that for ETFs and mutual funds that seek to offer exposure to the same bond subsegment, it is the ETF that has the more robust liquidity profile, as the transactional flexibility is greater. This is a benefit to ETF investors.
Let’s say we are just talking primary market transactions. ETFs still win out in terms of liquidity due to an inherent mismatch as a result of an operational nuance associated with mutual funds. Sales of mutual fund shares settle Trade Date + 1 day (T+1). Both primary and secondary ETF trades settle T+2, as do the underlying bonds. Therefore, mutual funds have a natural liquidity mismatch that managers must account for, which may pose potential issues in a significant selloff. This time, it is the operational flexibility of the ETF that creates a more supportive liquidity profile.
No deep impact
The last of the three major arguments among market participants is the impact ETFs may be having on the underlying securities. This argument is tangential to the above. And yes, this is where a chart comes in—after all, I am known in some circles as Chartolini.
Here I can show the additive liquidity provided by the secondary market to investors through the secondary-to-primary market ratio, as well as the size and overall diminutive market share fixed income ETFs have of the underlying bond market—all at the bond sector level. Here is what I did:
- Took every ETF listed within each of the respective bond sectors tracked
- Measured their total secondary market trading volume over the past five years as well as their gross daily primary fund flow activity (gross will show the absolute value of redemptions and, therefore, the full primary market activity impact)
- Aggregated those figures to create a sector level secondary-to-primary market ratio
- Used the same bond sector ETF assets under management to show the relative size as a percent of the total bond sectors’ underlying market value, as measured by investable indexes
As shown below, the size of the fixed income ETF marketplace is small relative to the broader bond market. This should abate the fears of those who believe that price discovery is being impaired by fixed income ETFs taking over the world.