Why bond ETFs have little to fear

Mark Wiedman believes the corporate bond market is facing big problems when interest rates start to rise, but the global head of BlackRock Inc. iShares isn’t overly worried about the impact that might have on his firm’s lineup of fixedincome exchange-traded funds.

To the contrary, Wiedman sees no reason to believe that ETFs will be any less resilient than they were in previous periods of market stress despite growing concerns from others that the liquidity underpinning corporate bond ETFs is already lacking and will deteriorate further in a major downturn.

“People say ETFs will blow up under the stress, but they only became more active in difficult periods previously,” he said in an interview this week. “They actually performed better.”

Wiedman said the risk of a liquidity crunch for corporate bonds is very real, especially when the U.S. Federal Reserve starts to raise rates, perhaps as soon as later this year.

He said it’s become much harder to trade bonds since the financial crisis because regulations have made it increasingly expensive for banks to fulfil their market role as primary dealers intermediating on behalf of buyers and sellers.

“They have responded rationally by cutting back their activities,” Wiedman said.

“Some banks have shuttered their fixed-income operations, others have cut back on the inventory they carry.”

At the same time, the supply of corporate bond issuance has continued to increase, resulting in a lower proportion of outstanding bonds that banks readily have available to trade as primary dealers.

But while the primary market for corporate bonds is negatively affected in this scenario, the ETFs that are invested in them are not impacted in the same way, Wiedman said, leading more and more fixed-income investors in that direction during times of stress.

For example, the iShares iBoxx $ High Yield Corporate Bond ETF units trading in the U.S. spiked in terms of a percentage of the overall cash bond volume trading after the Lehman Brothers collapse in 2008 and there was another big spike following former Fed chair Ben Bernanke’s taper speech in 2013.

That’s because ETFs do not rely on a primary dealer, Weidman said, and trade on exchange or secondary markets that allow buyers and sellers to transact without a bank intermediary.

ETFs, in other words, provide secondary or incremental liquidity to the primary bond market and offer investors a transparent, continuous price even when the banks shut down.

“Some observers say this liquidity is illusory, but that’s not the case,” he said. “It’s real secondary liquidity that is not touching the primary liquidity in the underlying bond market.”

Of course, ETFs trade on the primary bond market in order to create and redeem shares, but Wiedman said the vast majority of trades are performed on the secondary market, even in periods of market stress.

“The worst-case scenario for the liquidity of an exchangetraded fund is that it acts in accordance with the underlying market, and that would only happen if the secondary channel broke down entirely and there was no price that buyers and sellers can agree on,” he said.