Why ETFs may be the biggest bond worry

[4x4]

http://www.cnbc.com/id/101890512

From CNBC

Declining credit standards among bond issuers may be worrying analysts, but the papers' buyers, especially exchange traded funds (ETFs), could also pose big market risks if liquidity dries up.

"The ownership is more sensitive to retail flows," with around 37 percent of U.S. corporate credit held by households and funds, Alberto Gallo, head of European macro credit research at RBS, said in a phone interview Friday.

"There's a chance for snowballing if there's negative performance and investors withdraw even more money," similar to the taper tantrum, he said.

Last year, global markets suffered a massive rout after the U.S. Federal Reserve first broached its plans to begin tapering its asset purchases, as expectations that would cause interest rates to rise spurred an outflow of funds.

While mutual funds may have as much as a 5 percent cash balance they can use to settle redemptions, ETFs' cash cushion is smaller, generally as little as 0.5 percent, Gallo noted. He is concerned about corporate credit and high-yield bond ETFs, rather than government bonds.

"These may have to sell even more bonds," he said. "Some bonds are very small, but are held by a lot of mutual funds and ETFs. These are bonds that could fall under [more] pressure."

A pressing need to sell bond holdings could strike even as the liquidity of the secondary bond market has already tightened. While credit trading volume has been stable at around $20 billion a day over the last five years, the corporate bond market has grown by around 60 percent since 2007, RBS said in a recent report, noting SEC data indicates around 20 percent of corporate bonds don't trade at all.

The bank's proprietary measure, dubbed the "liquid-o-meter," indicates credit market liquidity has declined about 70 percent since the 2008 financial crisis, based on a combination of market debt, trading volume and transaction costs.

"Low liquidity means the exit door is becoming smaller," it said.

Bond markets are already seeing outflows. Over the past two weeks, U.S. bond ETFs and mutual funds have seen outflows of $1.56 billion and high-yield funds have seen $11.87 billion flow out over the past three weeks, according to data from Jefferies.

Other analysts are also concerned about how well the bond market's liquidity will hold up.

"It's the same concern as a run on the bank. Everyone puts their withdrawal notice in at the same time," said Kumar Palghat, managing director at fixed income manager Kapstream Capital, which has $7.3 billion under management. He noted that versions of this scenario played out during the taper tantrum and the 2008 financial crisis.

He noted that investment banks, which previously provided much of the market's liquidity, have changed their business model and are generally no longer willing to buy bonds and hold them on their books.

"Now they have to find another buyer," Palghat said. "They trade more derivatives than they trade cash bonds."

It's enough of a concern that Kapstream has moved about 25 percent of its portfolio into the more liquid end of the bond market -- including sovereigns, quasi-sovereigns, cash and supranationals, such as paper issued by the World Bank -- even though it means giving up some returns.

—By CNBC.Com's Leslie Shaffe

Submitted for your consideration.
Game changer or usual nothing to see here?

[barrett]

Interesting. Any thoughts here on what an investor holding individual 30-year treasuries might experience in the event of massive withdrawals on bond funds? Would the 30-year issues get beaten down in price or would bond holders still be looking for "high quality" bonds? Neither of the above? And why should this potential scenario be any worse for bonds than it would be for a gold ETF or stock funds?

[dualstow]

Interesting. Any thoughts here on what an investor holding individual 30-year treasuries might experience in the event of massive withdrawals on bond funds? ...

Well if they get out of bond funds and immediately get into individual bonds...

[barrett]

Exactly my thinking, Dualstow. Think of all the jewels we shall be able to buy!

[dualstow]

Exactly my thinking, Dualstow. Think of all the jewels we shall be able to buy!

LOL

[Tyler]

Key quote:

He is concerned about corporate credit and high-yield bond ETFs, rather than government bonds.

Who knows -- if corporate bonds tank, money may actually flow into treasuries.  Treasury funds certainly aren't without risk, bit in the market all decisions are relative. 

[Libertarian666]

Key quote:

He is concerned about corporate credit and high-yield bond ETFs, rather than government bonds.

Who knows -- if corporate bonds tank, money may actually flow into treasuries.  Treasury funds certainly aren't without risk, bit in the market all decisions are relative.

If corporate bonds tank due to credit worries, Treasurys should go WAY up. That's because they are "risk-free"! 

[Kshartle]

Key quote:

He is concerned about corporate credit and high-yield bond ETFs, rather than government bonds.

Who knows -- if corporate bonds tank, money may actually flow into treasuries.  Treasury funds certainly aren't without risk, bit in the market all decisions are relative.

If corporate bonds tank due to credit worries, Treasurys should go WAY up. That's because they are "risk-free"! 

Or there will be a 2 trillion bailout of corporate america to ummm....protect the vital industry or the grannies holding bonds or keep faith in 'merica or some other ridiculous excuse for them to counterfeit.

In which case Gold will go way up. Also there's no credit risk in a lump of shiny metal.