The largest US equity venue for exchange-traded products has rebuffed claims that the rise in popularity of bond based instruments threatens the stability of financial markets.
Bats Global Markets released a research paper on Tuesday claiming that Exchange Traded Funds could be the “release valve” if bond markets come under intense pressure, rather than exacerbating liquidity and compounding volatile swings in market prices.
The market for fixed income ETFs continues to boom as long-dated debt has recorded double-digit gains so far this year. Inflows into fixed income ETFs this year stand at $70.35bn, outpacing the larger universe of equity ETFs which have seen inflows of $54bn, according to Bloomberg data.
Gaining exposure to bonds via an ETF is cheaper and easier to execute than buying bonds outright or through a mutual fund. ETFs allow investors to trade shares on an exchange on a basket of underlying assets, typically trading far more frequently than the assets they seek to track.
The growing appeal of bond ETFs at a time when bond yields are close to record lows, however worries many in the market. A pronounced rise in bond market yields, as seen during the US taper tantrum of 2013 and the German Bund shock of 2015, is seen being exacerbated by ETF outflows.
Carl Icahn made headlines last year when he called BlackRock — the largest asset manager in the world and owner of the iShares brand of ETFs — a “very dangerous company”, homing in on the company’s junk bond ETFs that he said could seize up in the face of a shock to markets.
The Bank for International Settlements’ 2015 annual report also highlighted “the risk of liquidity illusion: market liquidity seems to be ample in normal times, but vanishes quickly during market stress”.
Regulators have also raised concerns. In August 2015, US trading of equity ETFs was halted a number of times and subsequently prompted Luis Aguilar a commissioner at the US securities and Exchange Commission to ask: “Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to re-examine the entire ETF ecosystem.’’
However, Tony Barchetto, head of corporate development at Bats, counters: “We think fixed income ETFs can be the release valve rather than a pain point. We don’t believe they make things worse, they make things better.”
We think fixed income ETFs can be the release valve rather than a pain point. We don’t believe they make things worse, they make things better
– Tony Barchetto, Bats
The Bats research shows the difference between the price to buy and the price to sell an ETF — a key indicator of market liquidity — does increase during periods of turmoil and the amount available to trade declines.
Bats concluded that trading remained reasonably orderly across a number of historical periods of volatility, including the taper tantrum, and more recently, during the closure of Third Avenue, a junk bond fund that suffered rapid redemptions.
“Yes, you do get less liquid conditions but this is normal,” said Mr Barchetto. “Any asset class, any instrument under stress, is not going to see the same liquidity.”
Overall trading volumes also dramatically increase and the research adds that because of high trading volumes, ETFs allow the underlying bond market an additional source of price discovery, helping trading across credit products.
The rapid growth of bond ETFs follows aggressive global central bank policy contributing to a flood of corporate bond issuance at low interest rates in recent years, with 2016 on pace to be another record year, according to data from Dealogic. Investors have also shifted toward bond ETFs to hedge against declining bond ETFs in the wake of a shrinking credit derivatives market.
Bats lists over 100 ETFs and 25 fixed income ETFs and is one of the largest ETF exchanges alongside rivals Nasdaq and the New York Stock Exchange’s Arca. BlackRock estimates bond ETFs make up about 0.6 per cent of the $100tn global bond market.