By Gregory Zuckerman, Katy Burne and Sarah Krouse
The Greek government is working on a bailout, Chinese stocks are
slumping and U.S. investors are counting down to an expected
interest-rate increase.
But what is really concerning a growing number of investors is
whether a crisis is brewing in the expanding world of
exchange-traded bond funds.
Bond ETFs have emerged as one of Wall Street's most lucrative
niches in recent years, promising buyers the steady income of bonds
in a package that is as easy to trade as stocks. Now, a building
chorus of investors--including activist investor Carl Icahn--is
warning that this best-of-all-worlds pitch may be a mirage. They
argue that troubles could arise if the bond market has a sharp
showdown, perhaps due to higher interest rates, and investors in
ETFs start heading for the exits.
So far, most ETFs have held up nicely and investors have
continued to shift money to the ETFs, which trade on an exchange
and typically track an index or other basket of assets. And the
hand-wringing partly stems from investors' painful memories of
2008's market collapse and their vigilance over any emerging
dangers.
But at a hedge-fund conference in New York on Wednesday, Mr.
Icahn said some ETFs have bought so many riskier and infrequently
traded bonds that it isn't clear who will buy them, or at what
price, should the funds be forced to sell during a market
panic.
In doing so, he joins skeptics who say ETF selling could spread
the effects of a downdraft, because the ETFs are widely held by
individual investors, who often flee in a market downturn.
Mr. Icahn made his comments in a confrontational session with
Laurence Fink, chief executive of BlackRock.
Mr. Fink said Wednesday on an earnings call with analysts that
the funds added to market liquidity in part because buyers and
sellers of ETFs interact with each other without affecting the
underlying basket of assets.
Last month, Bill Gross, who helped found bond giant Pacific
Investment Management Co. and now runs a fund for Janus Capital
Group Inc., sent a note to investors bemoaning the lack of
liquidity and how "mutual funds, ETFs, and even index funds" might
be hit in a downturn.
"The obvious risk--perhaps better labeled the 'liquidity
illusion'--is that all investors cannot fit through a narrow exit
at the same time," Mr. Gross wrote.
One leading high-yield ETF, BlackRock Inc.'s iShares iBoxx High
Yield Corporate Bond ETF, traded more than 20,000 times on average
each day, according to the firm. But each of its top 10 bonds only
traded 13 times a day on average.
High-yield ETFs had their biggest inflows on record in the week
ended Wednesday, taking in $1.5 billion, according to fund tracker
Lipper.
The iShares fund, which trades under ticker "HYG," saw $1
billion of that cash.
"The reality is that the ETFs are really only as liquid as their
underlying assets," said Deborah Fuhr, founder of London-based
exchange-traded product consultancy ETFGI LLP.
"You can trade small amounts on a secondary basis, but the real
liquidity, when it comes to sizable trades, is the liquidity of the
underlying" bonds she added.
Mike Buchanan, deputy chief investment officer at Western Asset
Management, said longer-term investors needed to consider that
despite "minute-by-minute" liquidity in ETFs themselves, the
underlying asset class, particularly fixed income, rarely trades so
frequently. "There's a bit of a mismatch there," he said.
Bond ETFs now own 10.5% of U.S. taxable bonds, a record, up from
8.26% two years ago.
All told, investors have put more than $100 billion into
fixed-income ETFs over the past 18 months ended in June, according
to the fund tracker Lipper.
BlackRock hosted a conference call for clients on Thursday with
senior executives on fixed-income market liquidity. It included a
discussion on how fixed-income trading and market structure has
evolved since the financial crisis and how bond ETFs can be used to
invest in fixed income alongside traditional investments.
A BlackRock spokeswoman said in a statement Thursday: "In recent
periods of market stress, ETFs have been adding liquidity beyond
what's available in the underlying bond market. They have been
tested and performed. That's why, rather than part of the problem,
they are part of the solution."
The Bank for International Settlements in June highlighted an
increased reliance on bond mutual funds and ETFs by investors as a
"key change" in fixed-income markets.
"The growing size of the asset-management industry may have
increased the risk of liquidity illusion: Market liquidity seems to
be ample in normal times, but vanishes quickly during market
stress," the BIS wrote.
The Securities and Exchange Commission in June asked for public
comment on new and complex exchange-traded products.
As part of the review of how products are listed and traded, the
SEC is seeking feedback on products investing in less-liquid assets
"including fixed-income instruments" in times of market stress.
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