ETF Trends
ETF Trends

Exchange traded funds are only as liquid as their underlying markets. However, if the underlying assets are notoriously illiquid, ETF investors could be in trouble during more volatile conditions.

For example, bond ETFs have become popular ways for investors to play a deeply illiquid junk and leveraged loan market. While the underlying bond and loan markets remain difficult to trade, bond ETFs have quickly attracted a huge following, writes Stephen Foley for the Financial Times. [Liquidity Concerns in Corporate Bond ETFs]

Due to the rapid growth in the ETF space, more investors and traders have turned to bond ETFs as an alternative to trading in the illiquid underlying bond markets. However, these bond ETFs may come with considerable risks, especially in a period of significant market stress. [Time to Reconsider Bank Loan ETFs]

“No investment vehicle should promise greater liquidity than is afforded by its underlying assets,” Howard Marks said in a note to Oaktree clients. “If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually illusory, fleeting and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times.”

Bond ETFs track a basket of fixed-income securities. Consequently, the ETFs are only as liquid as their underlying assets. In times of heightened market volatility, the bond ETFs may see a heavy redemptions, and without the necessary buyers in the underlying market, bid-ask spreads with rise and prices could fall even further. In the worst case scenario, bond ETF investors may even face a sudden fire-sale. [How ETFs Are Traded]

In this case, some fixed-income observers are concerned that the low liquidity in the debt market could cause problems in bond ETFs if a large sell-off were to occur. For instance, selling pressure in the ETF may not be perfectly reflected by the illiquid underlying market, creating widening tracking errors between the ETF’s price and net asset value.

“Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it) … Just when you need liquidity most, it tends not to be there,” Marks added.

Looking ahead, with the Federal Reserve eying a possible interest rate hike, bond market participants are growing more concerned.

“There seems to be a conflict between low liquidity in markets requiring more and more predictability and the Fed wanting to have more flexibility,” Deutsche Bank economist Torsten Slok said in a Wall Street Journal article. The “lack of liquidity could trigger a volatile reaction in fixed income markets as investors re-position for whatever decision the FOMC takes.”

Nevertheless, regulators are aware of the problem and are taking steps to help obviate the risks. For instance, the Securities and Exchange Commission is working on rule changes to the creation and redemption process of ETFs, allowing ETF sponsors to use similar debt securities as an alternative when creating ETF shares made up of difficult-to-find or less liquid securities. [SEC Could Amend Rules, Bolster Bond ETF Liquidity]

For more information on the fixed-income market, visit our bond ETFs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.