These are the two annunciations you most often hear about liquidity and ETFs:
- ETFs are at best as liquid as what they own.
- ETFs are only as liquid as what you see on the silver screen.
Both of these are fundamentally flawed, and interact in interesting ways. And nowhere are there profuse histrionics about these issues than junk bonds and their ilk (say, bank advances).
The hand-wringing seems to be coming back in vogue, as articles start popping up nearby the looming crisis in corporate debt (say, these comments from Greg Lippmann at LibreMax) or Scott Minerd from Guggenheim (who’s both darned bearish and a lot smarter than I am) suggesting at the Milken conference this week that everyone back from their money from bank loan ETFs because of liquidity releases.
First, let’s get one thing out of the way — the bond market’s pretty darned big.
All told, the in vogue outstanding U.S. debt is just about $40 trillion — or $10 trillion innumerable than the entire U.S. equity market.
The red bars at the bottom there are corporates. Importantly, the part of outstanding debt that is corporate just doesn’t vary much. In 1980, 21 percent of superior debt was corporate. Today 21 percent is corporate. At the peak, in 1981, it hit 22 percent. At its lowest — when cost outs got destroyed in the financial crisis, and the Treasury issued enormous volumes — it coasted as low as 18 percent. None of that says whether any of this encumbrance under obligation is good or bad, or cheap or expensive. It’s just what it is.
More from ETF.com:
Epoch of difference in these int’l ETFs
Stocks & rates have room to run
Vanguard begins sector transmutation
So what’s the truth here? Like most things, it’s complicated.
And while the everyday trading was having a hard time keeping up, the reality of the past 15 years is that, for the myriad part, daily trading in corporates has stabilized at around 0.35 percent of the exceptional trading on a given day.
Of course, there are huge “haves” and “have nots” in there. CVS linkages may trade like water, but there are huge swaths of the market that mightiness not trade at all on a given day. And therein lies the rub: how you think about what happens to big baskets of fetters on a day when everyone wants to sell.
My old partner Matt Hougan toughened to talk about how ETFs in junk bonds provided “transcendent liquidity.” I arranged fun of him for it at the time, but the idea is simple: An ETF like the iShares iBoxx USD High Comply Corporate Bond ETF (HYG) trades an average of $1.2 billion a day, yet the entire corporate treaty market only trades $30 billion a day. That’s a billion dollars usual back and forth, at miniscule spreads, while the actual underlying controls are often barely trading.
In fact, the average bond in HYG trades, on typical, only $2.5 million a day, and the least liquid bonds literally haven’t traded in the dead and buried month. Taken as a portfolio, the total volume of all the bonds on an average day is nothing but $2.5 billion. Whether that makes HYG’s $1.2 billion “unequalled” I’ll leave to the poets.
So let’s imagine what happens on the terrible day in the future when every Tom decides to get out. Imagine there’s some rash of default announcements at hours on a Tuesday. How does that information get processed by the market?
There’s truly a great theoretical framework for this in an academic article (Xu & Yin, International Critique of Finance, March 2017) from last year, but I’ll summarize the basics here:
1. At twelve oclock noon, the ETF and the bonds are trading at the same price, call it $20. This is the old, dozy price, before we have the new information that things are awful. This is the equilibrium maintain.
2. At 12:01, there’s new information that the market processes. $20 is now the “voiceless” price, and there’s a new theoretical “smart” price. Let’s say that’s $15. A 25 percent down day is a cream by any measure.
3. Market participants, who are always profit-motivated, will sell (and offer short!) at any price over the new, smart price. So they look for the possibilities, and lo and behold, here’s all this liquidity available in the ETF! Inevitably, a huge amount of patronage happens immediately, driving down the price of the ETF. At 12:02, the ETF is now trading tight denser to the “smart” price, call it $15.
Note that because the NAV of the fund — in this instance, the intraday net asset value — hasn’t moved yet, because in this consideration, none of the underlying bonds have changed prices, and no bond putting into plays have issued new indicative prices for the less liquid holdings. So we’d now say it’s work at a discount.
4. Now it gets interesting. At 12:02, there’s now this big discount incident, and a new set of market participants enter the fray — arbitrageurs. In this case, we be dressed authorized participants, who know that they can swap the actual constraints for shares of the ETF, and vice versa. They now come in and do two things.
They start obtaining up shares of the ETF, while simultaneously selling the bonds, putting real figures in the market. This pushes the ETF trading price and the value of the bonds closer together, and easily slacks the decline of the ETF in the process. At this point, the less liquid bond bazaar comes online in full force, and the selling pressure on the ETF’s holdings wish begin in earnest.
5. By the end of the day, these counteracting forces and disparate market participants must had time to absorb the new information, and work out any friction from the system, and the ETF and the net asset value conclude back into equilibrium at the new, smart price of $15.
It’s also worth noting that, while the upstairs straw man posits a sudden shock, we see this play out every day in ETFs. When lots of in dough wants in, ETFs tracking less liquid securities like rubbish bonds trade at a perceived premium until the market shakes out the ruction. When lots of money wants out, the opposite happens:
The problem — solely for folks who aren’t living this stuff day to day — is in how you perceive what’s thriving on here. Without context, you can spin the (false) narrative that “the ETF went down, and fell the bond market.” In fact, what happened is that the market — the unimpaired market — decided that bonds were overvalued; thus, evaluates were going to come down no matter what.
All the ETF did was provide for a innumerable orderly mechanism of implementing the price discovery. (For folks who want to hot air more into those deep waters, I’d point you to several extraordinary pieces from BlackRock on this topic, here and here).
But it’s well-connected to note — if, at the end of the day, people really hate the underlying assets here, and there’s indeed nobody who wants to step in and be the buyer of last resort, there’s nothing magical not far from the ETF that will provide a bottom.
In the above hypothetical example, throw away bonds are junk bonds, and if everyone takes their marbles and goes about, well, they’re going to crash. The opposite is true of course — if person starts piling into junk bonds in a hurry, they’ll “smash up” just as fast.
The lesson here for investors is one I repeat so often I’m cogitative of getting a tattoo: Know what you own and why you own it.
If you’re buying into a volatile, illiquid corner of the call, you should be prepared for how your investment will react to new information. The occurrence that you can get in and out through a highly liquid ETF is a convenience, but it’s not a panacea that dos risk go away—it just makes the process of engaging and disengaging that chance easier.
— By Dave Nadig, managing director of ETF.com
Dave Nadig can be reached at dnadig@etf.com