Daily Credit ETF and Index Summary (12.02.23): Bond Liquidity – Blessing or Curse?

The two HY ETF’s I have focused on, have added over $5 billion in assets this year alone.  That pace has slowed, in the past week, but these inflows have garnered a great deal of attention.  It is now a topic de jour at real high yield bond trading desks and not just at the fringe with nothing better to do.  Not only are the inflows being noticed, but so is the liquidity.  The ETF’s have daily turnover that, while tiny in comparison to the CDS indices, is high relative to the volume of bond trading that is reported on TRACE.

One of the things that I hear more and more about is the “ETF bond” premium.  There is a view in the market that certain bonds, owned in size by the ETF’s, trade too rich to the market.  I’ve looked at some of these bonds, they do seem to trade “rich” to the market, but I think it is more a function of a “liquidity” premium across the market, rather than specific to ETF’s.

Hedge funds are focused on “liquid” bonds.  Hedge funds want to be able to get in and out of positions.  In a year when many junk bonds produce yields that are so low it would actually make sense to hedge the interest rate risk, the capacity to generate strong returns from building a portfolio and earning carry is minimal.  If you bought a portfolio yielding 7%, unleveraged, at the end of the year the hedge fund and the client both would have earned 3.5% (assuming 2 and 20 fee structure).  So the funds need leverage or bonds with a lot more yield.  In either case, liquidity is a primary concern.  We had at least 3 instances last year where liquidity in the market virtually evaporated, but there is a strong view held at many funds that they will be able to react first to a move and by holding the most liquid positions they will be able to manage their risk that way, rather than having to play the game of being whipsawed trying to use the liquid on the run HY CDX index to hedge illiquid bonds.  So the hedge funds are chasing liquid bonds across the credit curve. That discipline of remaining only in the most liquid bonds tends to take about 6 months of calm markets before it is forgotten.  In the meantime, although there is some willingness to dabble in small off the run issues, the hedge funds are just as much part of the liquidity premium built into the market as ETF’s.

Then there are the dealer desks.  They are living in a self-imposed Volcker rule world.  The street has dramatically reduced risk capital.  The tolerance for loss on any given trade, let alone day, or week, is minimal.  So traders are extremely conservative with what limited capital they have.  They are all too aware that they might get that dreaded tap and be told to sell a position.  So what do they own?  Only the most liquid bonds they can find.  They too want to have that ability to manage risk quickly and are sticking to the biggest, easiest to trade issues.  They aren’t as interested in supporting their small off the run issues, and certainly aren’t about to take risk in some other firm’s small off the run issue, so they concentrate and focus on the liquid bonds.  Besides, that what hedge funds and ETF’s are trading, so it makes perfect sense to be where the flows are.  But this adds to the “liquid” bond premium.

I think the richness comes largely from the drive for “liquidity” in the market rather than the fact that a bond is an “ETF bond” .  The ETF’s play a role, but that is too simplistic.  Maybe the “liquidity” premium is so high, because of how high yield bonds are traded?  The high yield bond market makes the trading scenes from the original Wall Street move look technically advanced.

So what to do about this “richness”?  Go ugly early, because you will anyways.  If we are really at the beginning of another wave of central bank funded liquidity with diminished problems in Europe, you might as well get a head start on it by buying the less liquid issues.  Personally, I think that we are in the eye of the hurricane rather than having seen the last of a hurricane, but that is a valid strategy.  Rather than complaining about how “rich” some bonds are, buy the “cheap” unloved bonds and outperform the ETF’s.  I haven’t seen many mutual funds pitch themselves as outperforming the ETF’s, but maybe they should.  The ETF’s have become the de facto index for the market.  If the ETF’s are really just loading up on rich bonds and driving those bonds to levels that don’t make sense, than a manager should be able to build a nice portfolio of non ETF bonds and outperform.  Part of the reason that hasn’t happened, is that many managers want those same liquid bonds, and aren’t comfortable buying the less liquid ones.  It is very hard to put a value on liquidity but maybe the pricing is more fair than people realize.  The perception that you can manage the risk rather than being wedded to a position is a strong motivator.  It shouldn’t be underestimated.

And that is the other reason for going ugly early.  Everyone owns the same bonds for the same reason – liquidity.  They are rich to the less liquid bonds.  But how liquid will they be if everyone owns them because they are liquid and they can sell them in a down market.  Who exactly will be looking to buy these in a down market?  The perception of liquidity will actually make these bonds less liquid in any minor reversal.  On any reversal, at first bids will fade on the illiquid but cheap bonds, and the liquid ones will trade, but if the reason for the weakness remains, the next stage will be the liquid bonds underperforming because everyone has positions and needs to sell.  The illiquid bonds just won’t trade during this stage, but until the liquidity premium is squeezed out of the liquid bonds, the value investors won’t step up.  So that second stage of any correction will be the liquidity premium evaporating and those bonds will trade far worse and less liquidly than most people thought.  It is at this stage that we often see the bounce, but if we get to a more severe correction, the illiquid bonds will again underperform.  With ZIRP and decent earnings and decent economic data, most people seem to believe a more severe correction is off the table, so why not shift into some cheaper less liquid bonds – especially when the liquidity of the others is an illusion in even a downturn.

And for an asset class that is viewed as “so safe” right now, it is worth mentioning HY17 only has 97 names now that Eastman Kodak has been removed.  So there have been 3 Credit Events since this index was created in September 2011 (just 5 months ago).  Yes corporations are sitting on a lot of cash, but it is not evenly distributed – why else would everyone be watching to see what AAPL does with its hoard of cash?