February 1, 2016 / 1:12 PM / in 3 years

Thriving ETFs may be stoking a 'liquidity illusion' for bonds

LONDON (Reuters) - Flows into exchange traded funds with exposure to fixed income markets are at record highs, a boost to thinning market activity but one that some fear could become a source of volatility.

With bond market trading squeezed by central bank buying and tighter regulation straining banks’ market-making capabilities, ETFs — baskets of securities that can be easily acquired on an exchange — are thriving.

Provider BlackRock estimates assets in European fixed-income ETFs have grown by 2.4 times since 2009 and that global fixed income ETF assets may top $2 trillion by 2025. That would make them roughly the same size as Italy’s sovereign debt market.

Flows into European bond ETFs: reut.rs/1PAQqKp

The market is still in its infancy. Assets under management in ETFs with exposure to European government and corporate bonds are worth roughly 56 billion euros ($61 billion), up from about 26 billion five years ago, according to Markit data.

“There has been a wave of flows into bond ETFs,” said Lydia Vitalis, who manages relationships with asset managers for Greenwich Associates. “You have a lot of liquidity locked up in ETFs and you’re going to see ETFs having a growing influence on the market place.”

That influence comes with risks which some market watchers, including the Bank for International Settlements, say are contributing to a “liquidity illusion”.

Liquidity, the ability to quickly execute large transactions at a low cost and with a limited impact on prices, has become a major concern in bond markets since central bank buying and regulation have weighed on activity.

ETFs trade on stock exchanges and are popular with asset managers. They combine liquid and less liquid assets, making it easier and less risky to gain exposure to the latter.

But because ETFs tend to trade in line with cash bond markets they could turn into a source of volatility if investors seek to exit their positions simultaneously, especially in corporate debt. Greater reluctance from banks to engage in market-making could result in fewer willing buyers when the tide goes out, exacerbating downward price moves.

“There is a problem of phantom liquidity,” said Rabobank’s head of rate strategy, Richard McGuire.

Challenging liquidity conditions partly explain why ETFs have gained favor with bond investors.

“Thinning bond market liquidity has helped drive institutional demand for ETFs,” said Brett Pybus, head of iShares EMEA fixed income strategy at BlackRock. “The trading of individual bonds is becoming harder, so we’re increasingly seeing investors who focus on this space starting to look at ETFs as another tool to complement what they are doing,” he said.

A report last week from financial services data firm Greenwich Associates said demand for bond ETFs is strong among institutional investors in Europe, with six in 10 ETF investors using them to access bond markets.

Vanguard, another big ETF provider, says ETF liquidity has little impact on underlying bond market liquidity because buyers and sellers on the exchange can offset each other’s transactions.

SHIFT

Still, growth in ETFs marks a shift in the liquidity risk from banks acting as market makers to asset managers, who may be better placed to take it on.

“If a bank gets its risk model wrong, that can have wider implications but even if the biggest bond ETF index in the world suspended its redemptions that’s not going to stop people getting money out of a cash point,” said David Amplett-Lewis, a portfolio manager at investment firm Smith and Williamson.

However, he says, as ETFs’ influence grows, their potential impact on the market needs watching.

“ETFs are not inherently risk dangerous, but in an environment of declining liquidity, as very large owners of bonds, ETF providers need to be open about concentration where it exists, and cognizant of the potential effects on orderly markets in the context of their investors’ expectations,” said Amplett-Lewis.

Graphic by Gustavo Cabrera Cervantes; Editing by Nigel Stephenson and Toby Chopra

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