Siu Kee Chan, investment manager, multi-asset at ING Investment Management (ING IM), believes that recent concerns over bond fund liquidity and redemptions are having an impact on the outlook for London-listed bond exchange-traded funds too.
There have been concerns about bond funds due to liquidity and redemptions. Is this a concern for the bond fund ETFs listed in London?
Yes, as with all pooled vehicles large continuous redemptions are always a concern. After many years of bond inflows where fixed income was the place to be on both continuously lower trending government yields and attractive return pick up in the credit and emerging market bond segments, we seem to have entered into a phase of outflows from fixed income type of investments. On the back of central bank actions and improving fundamentals in the economy, investors are making a shift up the risk curve and slowly moving to more risky asset. As a consequence, investors perceive the current upside opportunities are low in the bond space in an environment of low treasury yields and tight credit spreads.
Compared to the size of assets still in bond funds and ETFs, the recent redemptions are only marginal. Given the strong focus on central bank policy on removal of stimulus and its implications on bonds, we can see investor flow moving to other asset classes like equities and real estate. To some extent we have seen this already, but as mentioned this has only been relatively small. The great rotation from bonds into equities can be a very damaging one for all bond type of investments, and thus also for bond fund ETFs.
Could they meet large redemptions – in the US some large ETF providers recently had to suspend redemptions – could it happen here?
Yes. However, when we address liquidity on either mutual bond funds or bond ETFs it is important to take into account the differences as it will have different implications. The biggest and easiest difference to mention is that for mutual funds all cash flows are collected at the end of the day and traded to a set NAV, whereas an ETF is continuously priced throughout the day. Practically, this means that investors can place orders to buy and sell a mutual bond fund throughout the day, all orders are collected at the end of the day, and at that stage the manager is informed on the net new money or outflow. In the case of large redemptions the manager can be faced with a difficult situation due to the time constraints to sell enough bonds to match the redemption. And if not deemed feasible, the interest of all participants is to be protected and thus can lead to a suspension of redemptions. ETFs on the other hand are traded on exchange and will most likely in first instance not lead to a suspension of redemptions but rather in a widening of bid ask spreads and thus higher transaction costs. For example during the Japan earth quack, Japanese equity ETFs were still quoted, however due to uncertainty in the market, counterparties were asking for a much higher risk premium, but it was still possible to enter and redeem the ETFs. In the more extreme situation, also for ETFs there is a risk that liquidity and be too low and lead to a suspension on redemption as we have seen on the more risky types of bond ETFs during the 2008 financial crisis.
Should you avoid any kind of bond fund ETFs? E.g. ones invested in ones with longer durations? Or less liquid types of bonds?
Having a preference for certain type of bonds is primarily an investment view decision and second consideration is the choice in the different instruments on how best to play the investment view. To avoid longer duration bonds or the less liquid types of bonds can make sense only if the view on those fixed income assets is negative. In the choice of instruments it is important to look at the differences between the various providers how the trading process is arranged. In this context, it is favoured to choose a provider working with a multi dealer provider and thus working with many different authorised participants to create a price on the ETF, rather than a very restrictive ETF provider with only a limited number of authorised participants to set a price.
Are synthetic bond fund ETFs better in this situation? Do synthetic or full replication bond ETFs offer better liquidity in the case of large redemptions?
Both offer the same investment exposure. Synthetic ETFs are replication the index performance with derivatives whereas full replication ETFs are basically a proportional copy of the index. Should either one of these types of ETFs be faced with a large redemption, both will first need to raise enough cash to meet the redemptions and second keep the basket of remaining securities in check with the replication method of the index. The advantage of synthetic ETFs is most likely that fewer bond selling transactions will be required to raise the cash to fund the outflow compared to a full replication strategy, however the uncertain factor will be the dependency on derivatives. As we have seen before, at times of increased stress we see volatility increase, which makes pricing on derivatives implicitly more expensive. All together there are pro’s and con’s to mention on synthetic bond fund ETFs in such a situation.
Should you avoid bond fund ETFs because they don’t have an active manager like a strategic bond fund?
Personally, I do favour having an active manager in place to assess the attractiveness of assets rather than a mechanical way of investing. In the context of redemptions and liquidity, I have no strong opinion whether one should avoid bond fund ETFs for the lack of an active manager.