ETFs are the canary within the bond coal mine

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Ever for the reason that 2008 monetary disaster, policymakers and pundits have puzzled what would occur to the cogs of finance within the subsequent huge international market shock.

Now, they’ve a check case to dissect: the widespread market drama that occurred in March as Covid-19 unfold worldwide and economies started locking down. Whereas it’s nonetheless too early to go definitive judgment on the general resilience of banks and finance — for the reason that full tally of Covid-19 ache stays unclear — some curious micro-lessons are rising that deserve extra debate.

Take into account fixed-income alternate traded funds, that are monetary devices designed to trace an underlying company bond index. Again in 2008, when worries centred on company credit score defaults, regulators and traders tended to concentrate on banks. That was as a result of huge funding banks held huge inventories of company bonds and acted as market makers on this sector.

However the post-2008 reforms made it way more costly for banks to behave as market makers, so that they bought down their inventories. A lot of these holdings had been purchased by the ETF sector, which has exploded in dimension since then. “In mid-2007, broker-dealers held $418bn in company and international bond property that might be used for market-making exercise, however now these holdings account for lower than $60bn,” notes Customary and Poor’s. In distinction, ETFs’ company bond holdings jumped by greater than $500bn in that interval.

This has generated good charges for ETF managers and made banks extra sturdy. Nevertheless it left policymakers apprehensive about market liquidity, too. Market makers have an incentive to maintain markets buying and selling in a disaster. Nonetheless, entities akin to ETFs don’t, since they basically function on autopilot, shopping for and promoting bonds robotically to match an index. 

Thus, regulators have fretted that the change in possession was creating market “fragility”. Even in good instances “liquidity in company bond markets. seem[ed] much less sturdy” than earlier than, as a report from the Financial institution for Worldwide Settlements notes; in unhealthy instances, exercise would possibly freeze, it was feared.

So what truly occurred within the Covid-19 market check? The Cassandras had been partly proper: in early March, the marketplace for company bonds did certainly freeze. “Issuance in main markets stopped, mutual funds noticed sizeable outflows, and secondary market yield spreads to authorities securities widened very quickly,” the BIS says. Ouch.

Worse, the ETF market went haywire — seemingly confirming the fears. Most notably, in early March, the value of ETFs collapsed so dramatically that the funds misplaced their hyperlink to the costs of the underlying company bonds. Some traded at a 5 per cent low cost to the worth of their underlying property, in probably the most excessive moments of dislocation. 

That appeared totally weird on the time. Nonetheless, analysts have subsequently re-examined occasions with cool heads and two curious factors emerge. These are that ETF value swings preceded different market strikes, albeit in a extra excessive method. Plus, this volatility didn’t happen as a result of buying and selling dried up; quite the opposite, each day ETF buying and selling volumes exploded, operating 250 per cent increased than earlier than the disaster, and investor redemptions had been very modest in March in contrast with different asset lessons. 

Thus, it appears that evidently traders reacted to the company bond market freeze through the use of ETFs to hedge dangers, conduct value discovery and dump exposures they disliked. ETFs had been thus an investor crutch, not a market block.

Is that this use of ETFs sustainable? Sadly, nobody is aware of. On March 23, the Federal Reserve took dramatic motion to halt the freeze in company credit score, saying huge purchases of firm bonds. It’s attainable that if that Fed rescue had not occurred, the funky ETF costs may need finally precipitated these buildings to crumble. We are going to by no means know.

However traders must ponder three factors within the gentle of this saga. First, regulators are nonetheless grappling with all of the unintended penalties of the post-2008 monetary reforms. 

Second, since these reforms have modified market buildings, it will be silly to assume that previous fashions of liquidity provision are information to the longer term. The March journey round ETFs supplied a benign shock. However there are much less cheering examples to ponder: in March the US Treasuries market additionally acted extraordinarily unusually, due to hitherto-unrecognised hedge fund exposures. 

Third, as market buildings change, central banks and regulators must adapt. The BIS thinks the March occasions present that ETF “costs are extra reactive to market developments than the costs of the underlying bonds are, particularly at instances of market stress”. Thus, it believes that ETF “costs are in all probability extra appropriate inputs to monitoring efforts and to danger administration fashions, together with these underpinning regulatory capital calculations, than comparatively stale bond benchmarks”. 

That won’t please anybody who fears that ETF managers are already far too influential for their very own good. However the BIS evaluation appears lifelike. Or to place it one other method, what the Covid-19 market shock has proven is that whereas the banks performed a starring position within the final huge monetary disaster, non-bank monetary buildings, akin to ETFs, matter way more now, and never simply within the company bond world. Meaning ETFs deserve extra scrutiny and debate — from politicians, in addition to traders.

gillian.tett@ft.com

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