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MarketWatch photo illustration/iStockphoto More liquidity – ability to be traded – is a good thing for bonds.
As exchange-traded funds surge in size and popularity, they’ve taken heat from market observers. Too much money is invested in “passive” investments, the argument often goes. Any market hiccup that sends investors rushing for the door could lead to traffic jams, with markets unable to process all the orders to sell.
ETF industry participants argue otherwise. But a recent note from a bank — hardly an ETF insider — suggests such funds may actually be helping the situation in one sticky, but giant corner of the financial markets.
Related: Here’s why ETFs can’t bring down the financial system, iShares says
“With the increasing share of trading in ETFs, liquidity in the (investment-grade) corporate bond market has improved notably,” wrote analysts at BofA Securities in a note published Tuesday.
“Hallelujah,” said Todd Rosenbluth, head of ETF research at CFRA, of the bank’s observation. “This is the reality. Bond ETFs trade every day, even though the underlying securities may be less liquid.” As investors pile into bond funds, Rosenbluth said, “the whole bond market is enhanced.”
Here’s why. Bonds trade much less frequently than stocks, and it can be hard to gauge the value of those that have been outstanding longer or have longer maturities. So they trade less often, which in turn makes it harder to gauge their value, and so on.
But over the past two years, the BofA analysts noted, trades of illiquid bonds have increased notably.
That’s thanks to the inclusion of these otherwise illiquid assets in one large bond ETF, they determined. The iShares iBoxx USD Investment Grade Corporate Bond ETF LQD, -0.06% is often known by its ticker, LQD. It is “the king” of bond funds, Rosenbluth said, dwarfing its competitors both in terms of assets under management and trading activity, although lower-cost upstarts like Vanguard’s Intermediate-Term Corporate Bond ETF VCIT, -0.10% have drawn more inflows recently.
Read: Investors can’t get enough bond funds
“This highlights the importance of the ETF market as it provides a way for dealers to quickly offload risk from constrained balance sheets, which is especially important when transacting in illiquid off-the-run bonds,” the BofA analysts concluded.
For Rosenbluth, the advantages of inclusion in an ETF seem tailor-made for bonds. It’s not just that bonds trade infrequently. There also are thousands and thousands of individual issuers in “the bond market,” ranging from municipalities to sovereigns to corporate entities. They’re all issuing debt for different reasons, at different durations, with varying credit profiles and collateral.
Bond ETFs have about 20% of total ETF assets, and gathered just under half of all inflows into ETFs last year, Rosenbluth noted.
Investors in recent years have poured into ETFs, which held a combined $4.4 trillion of assets at the end of last year, according to data from the Investment Company Institute, with $814 billion of that total attributed to bonds.
“Even within the investment grade space, there will be companies that have credit consequences and get downgraded,” Rosenbluth noted. “An index-based approach has merit for a lot of investors.”
