ETF RESEARCH ACADEMY OCTOBER 2015 INDEPENDENT RESEARCHERS’ LATEST FINDINGS
ETFs AND CORPORATE BOND LIQUIDITY
ETFs AND CORPORATE BOND MARKET LIQUIDITY—A HOT TOPIC
The liquidity of corporate bond ETFs is a hot topic for investors, traders, regulators and researchers alike. This is because corporate bond ETFs combine the key promise of an ETF (tradeability on demand) with an underlying asset class that’s traditionally been less liquid, for a variety of reasons1.
Bond ETFs have enjoyed great popularity, reaching US$450 billion in assets Galib Sultan under management in July 2015, around 15% by value of the near-US$3 Researcher, trillion global ETF market. But concerns persist that corporate bond ETFs University of could pose a threat to market stability3. Washington, Seattle In this Expert Opinion we highlight the key research findings of a recent paper on ETFs and corporate bond liquidity, written by Syed Galib Sultan of the University of Washington, Seattle. In his research, Sultan analyses the effect of corporate bond ETFs on the liquidity of the underlying corporate bond market.
Do ETFs help to create or consume corporate bond market liquidity? Using five different measures of liquidity, Sultan finds that, based upon empirical evidence from 2002-2014, the corporate bonds that are bought by ETFs tend to experience an increase in their liquidity as the ETF ownership of these bonds increases. However, this relationship may change during times of market stress.
1 Corporate bonds are often bought and held to maturity, rather than being traded. They are usually traded in the bilateral, over-the-counter (OTC) market, which offers lower levels of pre- and post-trade transparency than a centralised exchange. And corporate bond trading is highly concentrated in a relatively small number of issues. 2 http://www.bloomberg.com/news/articles/2014-09-23/etf-liquidity-risk-a-concern-for-regulators-wilkins
1 ETF RESEARCH ACADEMY OCTOBER 2015 INDEPENDENT RESEARCHERS’ LATEST FINDINGS
THE RESEARCH METHODOLOGY BASKET SECURITIES AND LIQUIDITY Sultan analysed quarterly holdings information for US Academics have studied the effect of “basket” securities, corporate bonds from the Thomson Reuters eMAXX database which allow a broad portfolio of securities to be bought via and manually identified ETFs from within the mutual fund a single transaction, on their underlying markets. Opinions category. He obtained US corporate bond trade data from differ on whether basket securities detract from or add to the Financial Industry Regulatory Authority’s (FINRA) TRACE the liquidity of the asset class they represent. For example, database. He then studied the effect of ETF ownership (and, academics have argued the following: more broadly, mutual fund ownership) on corporate bond liquidity using five popular liquidity measures. Sultan also —— Basket securities have a negative impact on the liquidity looked separately at the impact of ETFs on investment grade of the underlying assets because less informed traders bonds and high-yield bonds. migrate from the underlying markets to the basket securities. The “adverse selection” costs of trading in the underlying markets go up as a result (negative ETFs’ FOOTPRINT IN THE CORPORATE BOND MARKET impact) Despite the recent media focus on corporate bond ETFs, their footprint in the corporate bond market (when measured —— Under the “arbitrage hypothesis” the existence of basket by assets) is still relatively small. Sultan estimated that securities reduces information asymmetry and order ETFs owned on average around 1.5% of all US corporate imbalances, lowering arbitrage costs and increasing bonds during the period under review, with other types of liquidity (positive impact) owner (non-ETF mutual funds, pension funds, insurance companies) having a significantly larger ownership share. —— Under the “recognition hypothesis”, when an asset is included in a basket security, it gets recognised % Ownership of Corporate Bond Investors by investors in a positive way, generating increased interest, a broader investor base and increased liquidity % Ownership 60 (positive impact)
50 EXISTING RESEARCH ON CORPORATE BOND ETFs
40 AND MARKET LIQUIDITY Dannhauser (2014) looked at the impact of corporate bond 30 ETFs on the yield and liquidity of constituent bonds over
Café d’Accueil a shorter period (2009-2013) than Sultan. She found that 20 ETF ownership decreased yields on both investment grade 10 and high-yield bonds, while it had an insignificant effect on high-yield bond liquidity and a negative effect on investment 0 grade bond liquidity. She argued that her results support 19960 19980 20000 20020 20040 20060 20080 20100 20120 20140 20160 Year / Quartier the “adverse selection” theory: for investment grade bonds, liquidity traders exit the underlying market when a basket ETF% Bond Fund% Insurance% Pension fund% security exists.
Source: “A Study on the Bond ETFs and Corporate Bond Liquidity”, Syed Galib Sultan, Figure 1.
2 ETF RESEARCH ACADEMY OCTOBER 2015 INDEPENDENT RESEARCHERS’ LATEST FINDINGS
SULTAN FINDS A MORE POSITIVE IMPACT OF ETF WHAT ABOUT PERIODS OF MARKET STRESS? OWNERSHIP During a crisis there’s a sharp rise in illiquidity for corporate Sultan analysed the effect of ETFs on corporate bonds bonds and ETFs alike, as can be seen in the above chart using five measures of liquidity commonly used in academic for the Amihud ratio. But, based upon the analysis of studies: the Amihud (2002) measure, the Roll (1984) 2008, the effect of ETFs on the liquidity of the underlying measure, percentage of zero return and zero trade days, corporate bond market may also change during periods median imputed round-trip cost and turnover. of stress. Sultan found that, although the impact of ETF Whichever liquidity measure Sultan used (the chart below ownership on bond liquidity was positive across the 2002- shows the results for the Amihud measure), he found that 2014 period on average, during the 2008 crisis the impact the corporate bonds owned by ETFs are on average more turned negative, although he does not comment on the liquid than those not owned by ETFs. possible reasons for this empirical result.
Amihud- ETF bond, Non-ETF bond EXTENSIONS OF THIS STUDY
3 Sultan’s paper offers valuable insights into the relationship between ETF liquidity and that of the underlying corporate 2.5 bond markets. Further research on this topic could examine 2 the relationship during different market regimes, (e.g., 1.5 during other stressed periods, such as the 2013 “taper
1 tantrum”) to gain a better understanding of the linkages involved. Another potentially fruitful area of research could 0.5 be to analyse the liquidity relationship based on a different 0 segmentation of the corporate bond universe (for example, 20000 20020 20040 20060 20080 20100 20120 20140 20160 by bond index).
ETF bond Non- ETF Bonds
Source: “A Study on the Bond ETFs and Corporate Bond Liquidity”, Syed Galib Sultan, Figure 2.
Sultan also looked at the effect of ETF ownership on the liquidity of investment grade and high-yield bonds in isolation. Recently, ETFs’ ownership share of the high-yield corporate bond market has been increasing. He found that, in general, higher levels of ETF ownership contribute to higher liquidity scores for high-yield corporate bonds. However, this impact varies depending on the estimation technique and the liquidity measure used. The difference between Sultan’s and Dannhauser’s findings is striking and merits further research. The methodological approaches of the two researchers have some small differences, while Sultan’s research covers a larger sample period, including the financial crisis, and includes samples with more diverse classification.
3 ETF RESEARCH ACADEMY OCTOBER 2015 INDEPENDENT RESEARCHERS’ LATEST FINDINGS
RESEARCH PAPER - ABSTRACT
ETFs AND CORPORATE BOND LIQUIDITY His main conclusions are: The liquidity of corporate bond ETFs is a hot topic for investors, traders, regulators and researchers alike. This —— ETFs’ footprint in the corporate bond market is still is because corporate bond ETFs combine the key promise relatively small (ETFs owned 1.5% of the market during of an ETF (tradeability on demand) with an underlying the period under review); asset class that’s traditionally been less liquid. —— The corporate bonds owned by ETFs are on average Bond ETFs have enjoyed great popularity, reaching more liquid than those not owned by ETFs; US$450 billion in assets under management in July 2015, around 15% by value of the near-US$3 trillion global —— The impact of ETFs on the liquidity of higher-yielding ETF market. But concerns persist, particularly amongst (lower credit quality) corporate bonds is also generally regulators, that corporate bond ETFs could pose a threat positive, although the results vary somewhat according to market stability. to the liquidity measure used;
Researcher Syed Galib Sultan analyses the past effect —— The effect of ETFs on the liquidity of the underlying corporate of corporate bond ETFs on the liquidity of the underlying bond market may change during periods of acute market corporate bond market, using five measures of liquidity stress (Sultan cites 2008 as an example), although it commonly used in academic studies: the Amihud (2002) remains positive over longer measurement periods. measure, the Roll (1984) measure, percentage of zero Interestingly, Sultan’s key findings differ from those reached return and zero trade days, median imputed round-trip by other researchers: for example, Dannhauser (2014) cost and turnover. suggested that ETF ownership has a net negative impact on the liquidity of higher-quality (investment grade) bonds.
Further research may help throw light on these linkages and might focus, for example, on the relationship between ETF and bond liquidity during different market regimes, by market segments or by bond index.
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