At a time when big banks have reduced their inventories of corporate bonds to their lowest levels in years, fixed-income exchange traded funds have expanded their assets to a record high, as big and small investors use the funds to ride the great bull run in bonds.
The diverging fortunes have prompted some proponents of ETFs, which seek to replicate the returns of a variety of assets, to suggest they might help replace some of the bond market liquidity lost by the retreat of dealer banks.
“There’s a lot of discussion about ETFs as an alternative source of liquidity,” says Rob Friend, head of the fixed income business at Bloomberg, which has been bulking up its functions for fixed income ETFs. “As balance sheets get reduced on the sellside, the buyside is looking for other sources of liquidity in bond markets.”
ETFs promise investors the ability to dart cheaply and easily into and out of assets that might otherwise be more expensive or difficult for them to obtain.
This promise has attracted swarms of “mom and pop” retail investors as well as larger institutional investors such as pension funds, insurers and hedge funds. These investors have poured more than $1tn into fixed-income ETFs over the past few years.
The growing size of fixed-income ETFs has not gone unnoticed by bond traders at the big dealer banks. They say that the movement of money into and out of fixed-income ETFs can magnify swings in bond prices in an already thinly-traded market. “ETFs are definitely a part of our market,” says Rob Smalley, US credit strategist at UBS, the Swiss bank. “Large inflows or outflows do have a perceptible impact.”
That volatility was on full display this summer, when talk of the Federal Reserve “tapering” its emergency economic policies caused a sharp sell-off in bonds.
At least two of the big financial companies that support ETFs curbed “redemptions” on some of their fixed-income funds amid heavy one-way selling. Mr Friend says: “It’s hard to know exactly what’s going to happen. If the market decides that fixed income asset exposure needs to reduce, then people will need to think about selling those assets.”
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