How bond ETFs stopped a liquidity crunch

Between the U.S. government shutdown and the 2013 debt ceiling countdown, investors have a lot to be jittery about. And no other area of the market is as jumpy as bonds right now. Investors in fixed income have been reacting to the prospect of tapering since May, pulling money out of bonds in record amounts after a few strong years post-2008.

Tapering aside, the bond market is also getting hit by new regulations and capital requirements that have banks scaling back their bond trading businesses. This makes it even harder to get in and out of bond markets at a time when fixed income investors are keeping a close eye on the exit signs.

Such dynamics have put fixed income exchange-traded funds (ETFs) in a unique position. With investors focused on liquidity in the bond market at a time when it’s getting harder to find, they’ve been turning to ETFs to play the role, helping them get in and out fast, particularly in high-demand areas such as high-yield and investment-grade corporate bonds, according to this article in Institutional Investor.

Just how big a role ETFs are now playing in the bond market shouldn’t be underestimated. Fixed income ETFs now make up 20% of the ETF market, with about $250 billion invested. But their role is growing in other ways, according to a new study by BlackRock. It shows that during the most volatile months in the bond market (May 1 to July 5), some fixed income ETFs bore the brunt of the trading frenzy, not the underlying assets.

BlackRock looked at the iShares iBoxx $ HighYield Corporate Bond ETF (HYG) from May 1 to July 5 and found that Ben Bernanke’s comments on tapering in May led the HYG ETF—which had never traded more than $1 billion in shares in a day—to breach that level on each of the five days as investors reacted to the news. Investors were using ETFs—not the underlying bonds—to reposition their portfolios in light of the Fed’s comments.

Investors redeemed record numbers of HYG shares, but the redemptions, according to BlackRock, were offset by overall activity—activity that didn’t actually require anyone to purchase or sell actual high-yield bonds. So while trading activity spiked for the HYG ETF, the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine noted that the volume of high-yield bonds being traded day to day during the same time remained relatively stable.

So, basically, investors bypassed the underlying asset and went right for the ETF to rebalance their portfolios. Doing this meant that there was little volatility in the high-yield bonds tracked by the ETF.

On one hand, you could call it a clear case of the tail wagging the dog—and, in that case, it is worrisome for some market watchers. On the other hand, the ETF itself seems to have prevented a sell-off in the high-yield bond market, a phenomenon I’m not sure I’ve seen play out in markets before. The interplay between underlying assets and ETFs in less-liquid areas of the market certainly bears scrutiny going forward. But it might also point toward some new roles and uses for ETFs in the broader market as more investors begin to use them.