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Bond ETFs Threaten Markets, TABB Analyst Warns

Accelerating trading in exchange-traded funds that hold bonds poses systemic risk, says author of trading study.

The rise in trading of shares in exchange-traded funds that invest in corporate bonds poses a risk to the financial system, one analyst has warned.

ETFs are being used increasingly as a substitute for credit default swaps as a means of hedging against or speculating on companies’ creditworthiness, according to TABB Group analyst Henry Chien. In his report, entitled “Corporate Bonds and the ETF: Odd-Lot Arbitrage,” Chien says that this could magnify a market downturn.

The ease of trading on an exchange can potentially lead to large outflows that require block-sized liquidity in “an already challenged” bond market, he explained. “Any ‘forced selling’ may lead to negative feedback cycles that could also spread to other markets,” Chien said.

As corporate bond ETF trading accelerates, Chien observed that “unique liquidity dynamics and information flow of ETFs will increasingly impact prices and trading behavior in the underlying bond markets.”

He said that impact was already apparent in the pricing of ETFs’ constituent bonds, especially in the high-yield space. And Chien attributed the rise in use of bond ETFs to recent regulatory changes ranging from TRACE, a system that brings real-time pricing to the corporate bond market, to new limits on banks’ participation in the markets under Basel III and the so-called Volcker Rule, which he said served to “dismantle the dealer-driven, principal-based market structure.” Regulation, Chien said, “is simply accelerating a redesign of today’s credit market structure.” He added, “The nuances and subtleties of market making in corporate bond ETFs will lead toward an electronic, exchange-like market structure just at a time when regulation has broken up the old party.”

The report, based on interviews with brokers, market makers, dealers, exchange-traded fund issuers, alternative trading systems, exchanges, multi-dealer trading platforms and data providers in the ETF universe, found that trading in U.S. corporate bond ETFs accelerated during the first half of 2012, accounting for average daily bond volumes of $262 million, $146 million in par value in the investment grade and $116 million in the high-yield markets.

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