The quickening growth of bond exchange traded funds has drawn an increasing amount of concern over potential liquidity issues in the event of a sustained rise in yields.
Bond investors have turned to fixed-income ETFs that provide a relatively seamless way to gain exposure to the underlying debt markets, but critics argue that the funds have not be tested by a significant fixed income shock, such as mass redemptions in response to rising rates, the Financial Times reports.
A number of high profile investors, like Carl Icahn, have warned of the potential risks in bond ETFs, outlining fears that if debt prices suddenly plunge, investors may rapidly sell off ETFs, which could trigger a cycle of sell-offs and falling prices.
“I think it is very very dangerous to assume you can turn an illiquid market into a liquid market,” Gershon Distenfeld, director of high yield at AllianceBernstein, told the Financial Times.
Critics have grown louder in light of the bond ETF industry’s recent success. According to ETFGI, global fixed-income ETFs held over $600 billion in net assets under management as of the end of July 2006, compared to $60 billion at the end of 2007. Inflows into fixed income ETFs have outpaced equity ETFs this year, with bond ETFs bringing in $83 billion compared to $62 billion for stock ETFs.
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Meanwhile, loose global monetary policies have depressed bond yields and bolstered prices across the world, limiting the ability of active portfolio managers to outperform passive options, which further fueled the rush toward low cost index-based funds like ETFs.
The ETF industry, though, argues that bond ETFs provide a reference point for investors to more accurately price debt securities or improve price discovery.
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“The increased pricing discovery supported by daily ETF trading in the underlying fixed income holdings helps provide markets with bond prices for securities that otherwise might not have traded hands on a given day,“ James Meyers, director of fixed income product strategy at Invesco PowerShares, told the Financial Times.
For instance, ETF providers pointed to the ETFs’ performance during the closure of Third Avenue Management’s high-yield bond fund last December when high-yield ETFs’ trading volumes increased as investors tried to capitalize on deteriorating bond prices. Consequently, the industry argued that ETFs add liquidity to a market and allows investors more easily move in and out of a bond position without diving into the underlying debt market.
For more information on the fixed income market, visit our bond ETFs category.