No Country For Dead Labradors: An Inside Look At ETF Liquidity

| About: iShares iBoxx (HYG)
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Investors need to take a close up look at how bond ETFs work in the post-crisis world.

The middleman is gone.

"If someone yells fire."

Last week, I was the bearer of bad news: all of the Labradors had died.

That meant that the sponsor of the iShares Labrador Bond ETF was facing $15 billion in redemptions. But because all of the Labradors were dead, there was no market for the fund manager's Labrador bonds. The best the manager could do was unload the bonds for pennies on the dollar to someone who wants a lottery ticket on a Lazarus Lab. The price of the bonds plunges. So does the ETF.

It was a simple analogy meant to demonstrate an even simpler principle: As Howard Marks put it, "ETFs can't possibly be more liquid than the underlying."

If you think about it, that's common sense, but no one seems to get it. Kind of like how no one in the lead up to the crisis seemed to get that hundreds of discrete pieces of crappy collateral do not become un-crappy just because you pooled them.

In the Labrador bond story, I didn't assign $15 billion to the fictional Labrador bond ETF arbitrarily. $15 billion is the size of the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG). The defective Labradors represented junk bonds.

I thought I'd delve a bit deeper into how this works in the interest of helping investors understand why this situation is so precarious.

First, let's look at how the market has changed in the post-crisis world. Total HY debt outstanding has more than doubled since the crisis and yet turnover has plunged. As Barclays notes, "turnover is low [and] recent increases reflect higher volatility in commodities sectors, not structural improvements."

(Chart: Barclays)

Clearly, you don't want to be in a position where an inherently risky market is growing rapidly and isn't turning over.

But here's where it gets interesting. It's no secret that dealer inventories have shrunk dramatically in the wake of the crisis. Thanks to the new regulatory regime designed to eliminate "nefarious" prop desks, the Street isn't interested in holding inventory. The question is: how are fund managers coping? Here's a simple diagram from Barclays that shows how things used to work, and how they work now:

(Chart: Barclays)

So essentially, managers are swapping ETFs and CDX exposure depending on where the money is flowing.

You might note that there's a problem with that system. Namely, it only works if someone, somewhere has inflows. That is, if flows become "unidirectional" (as Barclays put it last year), it's not clear who the buyers will be.

Who knows how the CDX element would play out. In a crisis scenario, one would assume you'd want to hang onto your protection even as the redemption requests rolled in. On the other side, you'd probably want to buy yourself some protection, but it'd be getting more expensive by the day.

The point is: if everything starts moving in the same direction and there's no middleman, the post-crisis system depicted above will cease to function.

The SEC has moved to mitigate the problem by proposing a new liquidity management regime. One of the pillars of that regime is that a certain amount of fund holdings must be allocated to assets that can be converted to cash in 72 hours or less.

There's a kind of bucket continuum system here where highly liquid assets fall into bucket 1 and assets that it would take more than a month to convert to cash fall into bucket 6. Barclays took a look at where things stand currently based on what the bank calls a "simple volume-based approach for US high yield" and found that smaller funds look to be vastly more liquid than larger funds:

(Chart: Barclays)

If you ask me, that's probably not a good thing.

I'll let readers draw their own conclusions from the above, but I would note that if this gets moving in the wrong direction, you won't want to stick around in HY ETFs to see how it plays out.

In closing, here's a quote from Goldman which betrays the extent to which managers are apparently blind to the risks:

While HYG assets only accounts for 1.2% of the total High Yield bond market, the HYG average daily value traded is 15% of the total high yield bond market (year to date). This is up from 8% a year ago. Institutional investors tell us they prefer the stronger liquidity profile of the HYG vs cash bonds; they can adjust exposures quickly with the HYG rather than trading illiquid single name bonds.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.