Rapid Growth of Bond ETFs Could Fuel Credit Liquidity Risks | ETF Trends

The rising popularity of bond exchange traded funds could add to risks in a notoriously illiquid corporate debt market, especially during periods of heightened selling pressure.

Efe Cotelioglu, PhD candidate at the University of Lugano, the Swiss Finance Institute, has found that high-grade securities share similar liquidity characteristics when they are heavily owned by ETFs, Bloomberg reports.

Consequently, during extreme market shocks, investors dumping these securities will suffer the same liquidity problems across the segment. For example, during this year’s coronavirus pandemic-driven selling, corporate bond ETFs experienced a precipitous drop as investors scrambled to trim their holdings until the Federal Reserve’s support brought things back in line.

“Higher ETF ownership of investment-grade corporate bonds can reduce the ability of investors to diversify liquidity risk,” Cotelioglu said in a paper.

During the height of the volatility earlier this year, Treasury liquidity suffered a collapse, and gaps between the prices of ETFs and the bonds they track emerged. Once the Fed acted, the fixed-income markets resumed their calm.

Some have warned about the risks of bond ETFs that track a notoriously illiquid market as the growing popularity of ETFs could destabilize their less liquid underlying markets.

Cotelioglu pointed to an “economically and statistically significant” difference between the co-movement of liquidity in investment-grade bonds in the top-quartile of ETF ownership and those in the bottom quartile. Additionally, his research found no relationship between commonality of liquidity and mutual fund ownership, which he attributed to contrasting investor bases and structural differences since mutual funds have “discretion” in how to meet redemptions while an ETF can’t pick and choose what assets it sells.

The study was conducted based on a decade’s worth of data ended in the second quarter of 2019. The bond ETF market has since exploded, with fixed-income ETFs attracting about $170 billion in 2020 or more than equity inflows and already beating 2019’s record $154 billion in inflows.

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