US bond ETF decision raises market risk
The author is Managing Director and Deputy Chief Investment Officer at fund manager TOBAM
The market volatility triggered by the war in Ukraine reminds us that crises can reveal hidden strains and strains that have built up over time in the financial system.
Changes in market structures during boom times can turn into significant risks in the event of a sharp turnaround in conditions, particularly when trading liquidity dries up. Against this backdrop, investors should note a recent change in the financial plumbing of US markets.
The New York State Department of Financial Services recently decided to allow insurance companies to classify bond ETFs as individual bonds rather than stocks to assess their capital needs to meet solvency rules. .
At first glance, this seems economically prudent. These instruments do not represent an equity risk and therefore it is not logical to classify them as such. However, it is not entirely accurate to consider their potential risk as equal to the risk of an individual bond.
Low interest rates pushed companies to issue record amounts of debt in the years following the financial crisis, while the risk-bearing capacity of market makers was drastically reduced due to new regulations.
Investors have started using ETFs to replace the lack of liquidity providers. This increased importance of ETFs has created a very important new type of investor in the credit market: the ETF manager. The interests and investment objectives of these managers are not necessarily aligned with those of normal buy-side investors.
Today, three market players control 90% of the bond ETF market. This dominance is likely to be reinforced by the new ruling, given that the new ruling only applies to ETFs that have at least $1 billion in assets under management. It will push insurers even further into the select circle of very large funds managed by the same asset managers.
Bond ETFs typically track indices that focus on the most liquid part of the market. What should not be forgotten, however, is that these bonds are much less liquid than stocks.
This implies that passive investing in credit markets could negatively impact price discovery mechanisms. Moreover, since the one and only investment objective of passive managers is to stick to index replication, they do not have the leeway to move away from certain issuers or risks.
The credit market crisis of March 2020 was a very good illustration of the problems. This was the first real credit market crisis since bond ETFs were widely adopted. Bond ETFs were hit hard, suffering disproportionately.
While investment-grade ETFs accounted for about 30% of bond fund assets under management, about 50% of IG’s outflows came from ETFs, according to our calculations. In the high-yield space, outflows were nearly 40% from ETFs, although these account for less than 15% of HY fund assets under management.
As a result, the net asset value discounts at which fixed income ETFs traded during the March 2020 crisis were massive as a very large number of exits hit a very specific segment of the market which began to completely dry out.
ETFs track indices made up of bonds which are actually the most liquid part of the market. However, if there are large trades in this single market segment during times of stress, it will end up being as illiquid, or even more illiquid, than the rest of the market.
If central banks had not stepped in to support the financial system more generally, bond markets would have suffered, but ETF investors would have suffered even more.
Additionally, since most bond ETF assets are only managed by a few providers, this involves a concentration of algorithms to replicate benchmarks. This tends to put even more commercial pressure on certain bonds. This focus on the largest bond issuers also means that ETF investors do not benefit from investing in the universe of credit market risk.
This means, unfortunately, that treating bond ETFs as single bond investments from a regulatory capital perspective does not actually present the same kind of risks or equivalent long-term returns.
Despite the new regulations, insurance companies should consider a thorough and careful risk assessment of these investment instruments. This is especially the case if other regulators follow New York’s decision, prompting even more insurance companies to invest in bond ETFs.
Unlike March 2020, it is unclear whether central banks will be willing and able to intervene.