For fund managers, high-yield pullback comes with liquidity risks

Last Thursday, Jon Sablowsky’s three-headed Hydra of computer monitors lit up with offers from big Wall Street traders for him to buy millions of dollars in bonds.
By the end of the day, tens of millions of dollars would move out of exchange-traded funds that invest in bonds. That meant the traders who act as intermediaries between ETF issuers and their users sought to sell the bonds held in those less-desired funds, and they wanted to know how much they could get from the likes of Mr. Sablowsky for them.
“We’re seeing a lot of bids wanted from the ETFs,” said Mr. Sablowsky, who runs the trading desk at Brownstone Investment Group, a boutique bond dealer to registered investment advisers and other clients. “When they’re coming to sell, we’re definitely seeing additional pressure … they try and sell as much as they can.”
The day was most likely going to be unprofitable for Mr. Sablowsky’s 11-person team, but he was willing to be on the other side of trades because he believes the U.S. is still on a growth trajectory and corporate borrowers are still meeting much of their debt obligations.
But financial advisers and investors may have something to worry about when the fleeting optimism of traders isn’t sufficient to create a market.
“Where it will be an issue potentially is the next credit event when there are big redemptions of the balances that have flowed that way — I think it will be an issue,” said Jeff Layman, partner at Springfield, Mo.-based BKD Wealth Advisors. “Retail investors have gone heavily that way so to the extent that money flows out quickly, it will probably create some issues.”
Take one corner of the market, high-yield bond funds, where money is still pouring out. Over the last three weeks, investors have pulled $5.5 billion from those funds, according to Lipper, a Denver-based investment research firm. Fund managers, regulators and other market participants worry that high-yield — and other bond market sectors — could become more treacherous as a growing retail segment looks to withdraw money just as core liquidity providers have stepped out of the market.
Large broker-dealers that help provide a market for individual bonds to both retail and institutional clients are fewer and farther between. Firms with retail arms — like Morgan Stanley & Co., UBS Securities and Merrill Lynch, Pierce, Fenner & Smith Inc. — are now much more likely to be giving those clients exposure to the bond market through electronic securities-trading platforms or secondary products, including mutual funds and ETFs.
“The Street isn’t really equipped to absorb a lot of that demand,” said Michael J. Collins, senior investment officer at Prudential Fixed Income, a Newark, N.J.-based money manager with $418 million invested in bond markets. “That has really put a damper on liquidity and because of the limited liquidity in the market, I think it’s going to increase the magnitude of price swings.”

REGULATORY CHANGES

One reason for the dwindling number of liquidity providers is that since the financial crisis, legislators and regulators imposed new restrictions on large broker-dealers’ bank parents. The Basel III Accords imposed new capital requirements on banks globally. And in the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act’s Volcker Rule limited bank’s trading with their own money.
Those changes have made trading bonds more expensive, according to Anthony J. Perrotta Jr., head of fixed-income research at TABB Group Inc., a Westborough, Mass.-based capital-markets consultancy.
“While the overall market has grown, there’s been an absolute contraction in primary broker-dealer inventories,” said Mr. Perrotta. “What’s been more important is that the dealers’ willingness to provide immediacy — defined as immediate risk transfer for the holders of corporate bonds — has been in serious decline.”
Top dealers held $285 billion in corporate bonds at their peak, in Oct. 2007. That number fell to $37 billion last month, according to the Federal Reserve Bank of New York.
Yet even as Wall Street firms deploy less capital, buyers have increased both in number and dollar amounts. Mutual funds and ETFs represented a market of $3.5 trillion last year, up from $1.7 trillion in 2007, according to the Investment Company Institute.
The Federal Reserve’s unprecedented bond-buying program, known as quantitative easing, is credited with lowering the returns on the highest credit, lowest risk debt products, and with sending more money into lower-credit, lower-liquidity offerings like high-yield debt.
In recent weeks, flows into high-yield bonds, in particular, reversed sharply as a growing U.S. economy seems likely to presage higher interest rates amid growing possibility that the Federal Reserve may look to restrain upward inflation movement. Interest rates move in the opposite direction of bond prices.
Flows — like the $5.5 billion that drained out of high yield bond funds since early July — can inundate markets. Last Thursday, investors pulled nearly $643 million out of just three ETFs — iShares iBoxx $ High Yield Corporate Bond (HYG), iShares J.P. Morgan USD Emerging Markets Bond (EMB) and SPDR Barclays High Yield Bond (JNK) — all of which invest in relatively light-traded high-yield and emerging market debt, according to ETF.com, a San Francisco-based investment research firm.
That led ETF arbitrage traders, known as authorized participants because only they have the right to transact directly with issuers, to sell the underlying securities, which included corporate bonds from companies like Peabody Energy Corp., Terex Corp. and Ball Corp., mostly to institutional investors and broker-dealers.
But because the markets are small, compared with stock ETFs, prices in those bonds can swing sharply lower. And spreads — the difference, in yield, between high-yield bonds and the rest — can widen. Those price and spread differences can be driven primarily by the liquidity of the market, rather than fundamentals, like the bond borrower’s ability and willingness to repay its debts, according to institutional traders.
That’s exactly what happened in June 2013 after the Federal Reserve indicated it was going to unwind quantitative easing.
“Last year’s ‘taper tantrum’ is a good starting point to understand what this lower liquidity environment means for bond investors broadly and for credit investors specifically,” explained Ashish Shah, head of global credit at AllianceBernstein, a New York-based money manager with $480 billion in assets, about half of which is in fixed income. “We saw that redemption cycle — retail selling leading to prices going lower pretty quickly, and it generally takes a little while for institutional investors to say, ‘Hey, yields have gone higher, it’s attractive for me to buy.’”
After the taper tantrum, the Securities and Exchange Commission advised fund firms to make sure they properly disclosed the full risks of investing in bond funds and that recommended conducting additional stress tests on liquidity.