In spite of the boom in the US primary markets this month, the corporate bond industry faces a level of demand among asset managers far greater than issuance, leading to the adoption of new structures and technologies driving a rise in equity-style, fixed-income exchange-traded fund (ETF) use. In new research published today, TABB Group estimates trading in US corporate bond ETFs accelerated during the first half of 2012, accounting for average daily bond volumes of $262 million, specifically $146 million in par value in the investment grade and $116 million in par value in the high-yield markets. “As corporate bond ETF trading accelerates,” says Henry Chien, research analyst and author of “Corporate Bonds and the ETF: Odd-Lot Arbitrage,” “unique liquidity dynamics and information flow of ETFs will increasingly impact prices and trading behavior in the underlying bond markets.”
“As regulatory forces, mainly TRACE, Basel III and the Volcker Rule dismantle the dealer-driven, principal-based market structure,” he explains, “ETFs may be a key component in the interplay between institutional and retail flow and the move towards a live-price environment for certain bonds. ETF flows are increasingly impacting the price of constituent bonds directly, especially in the high-yield space. At TABB, our data suggests that bonds in high-yield ETFs tend to outperform comparable bonds as ETF inflows rise.”
The 20-page report with 10 exhibits is based on interviews with brokers, market makers, dealers, exchange-traded fund issuers, ATSs, exchanges, multi-dealer trading platforms and data providers in the ETF universe. It provides a detailed analysis of ETF market-making, impact on bond-market liquidity and trading behavior and the role they play in evolving credit market structure. According to TABB, fixed-income ETFs are being considered by institutions as a replacement product for credit default swaps (CDS). In addition, bond market participants are paying closer attention to ETFs now that bonds moving into the ETF universe – whether in creation or redemption baskets or any ETF-eligible issuance – are seeing a noticeable difference in liquidity as bond traders anticipate the impact of ETF market makers.
Addressing the issue of systemic risk in trading ETFs, Chien explains that the ease of trading on exchange can potentially lead to large outflows that require block-sized liquidity in an already challenged bond market. “Any ‘forced selling’ may lead to negative feedback cycles that could also spread to other markets.”
As ETF market-making in corporate bond ETFs continues to drive segmentation, a small concentration of the bond market will become more transparent and more active. “Still, you have to look deeper into these trends, Chien says. “There’s rapid product innovation, dynamic-trade technology and constant new arbitrage opportunities emerging in the ETF universe.”
The report is available for immediate download by TABB Group Research Alliance Fixed Income clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or for more information, visit http://www.tabbgroup.com or write to info@tabbgroup.com.