Dodos out, canaries in – how to fix the ills of the world’s corporate bond markets
It has been well over 100 days since that fateful day in late March when the Fed stepped in and said they would start buying Corporate Bonds as part of a much wider plan to help avoid a broader market collapse as outflows from Fixed Income funds ran riot.
As with most sequels, the follow up movie to the initial blockbuster never seems so dramatic. “Quantitative Easing I” released in 2008 and starring Ben Bernanke, had shown us how far the Fed was prepared to go when Wall Street had to be saved whatever the consequences.
Roll on 12 years later, and unless you were in lockdown at home and out of circulation, as a large percentage of the world’s population of seven billion actually was, you may have missed the rapid market sell-off and subsequent recovery. At long last here was the chance to settle some old scores. In fact I would not be surprised that in the same way that every one of us can remember exactly where we were when the Twin Towers collapsed, quite a number of us recalls that historic day, subsequent to the Covid 19 pandemic, when the Financial Times actually ran a piece praising ETFs and confessed they were not the villains after all.
Ok, I exaggerate, but nonetheless imagine my surprise when the FT’s journalist Gillian Tett published her recent article entitled “ETFs are the canary in the bond coal mine”. While begrudgingly reporting that the Bank for International Settlements had been particularly praiseworthy of the role that ETFs played during this year’s crisis, her article was laden with ambiguity. I’m not sure I am a buyer of Tett’s conclusion which in my opinion re-enforces the wrong-headed view that ETF managers are too influential for their own good, and for that reason they deserve even more scrutiny from politicians and investors.
Given the UK’s current Government’s inability to count or not ride roughshod over the scientific method, it would leave me with dread if I thought their opinion was to be an influencer in this debate. As for the investors, they have already voted with their feet. Just look at the numbers (ironically enough) in the article “ETF backers declare victory after largest ever stress test” written by Robin Wrigglesworth, also for the FT, and published after Tett’s article which highlights that active funds suffered large outflows over recent months as compared to the inflows of ETFs.
Both of these articles from the FT make for great reading and just go to show how far the whole debate around ETFs has moved on. Gillian Tett has a PhD in Social Anthropology, and from that vantage point it has been her ability to rise above the technical detail so beloved by the investment banking community. After the 2008 crisis, Tett’s research saw the problem as first and foremost a behavioural problem. The whole issue of inappropriate CDO ratings, an eco-system where having too many of the smartest people in the room at the same time, all contributed to the mother of all crises. There comes a point though, where one has to put that perspective to one side and truly ask what is wrong with the bond eco-system from an engineering perspective.
For many years, fund administrators have struggled to find a way to not be accused of representing a false market for the quoted price of illiquid Corporate Bonds, to no avail it seems. The consensus of what’s truly going wrong though, is already clear. If ETFs are to be likened to the canary in the coal mine, then the composition of corporate bond indices must surely be likened to the dodo of the pack. Not the simplest of situations to fix overnight for sure, but how hard would it be to put bond issuance onto a decentralised Blockchain ledger, and with that the details that would provide sufficient transparency to assess the true levels of liquidity?
Let’s face it, that’s how the equity markets work. In other business arenas, the utility of having one master database, accessible by all, is proving to be unstoppable, but why do bond indices still contain securities that statistically on any given day are not tradeable? Well, for no other reason than that’s the way it was done in the past. The dodo didn’t die out overnight, nor will limitations of the bond market’s infrastructure. It is simply a matter of time before Blockchain comes to the rescue.
Let’s wrap up by dealing with the misleading quotes that muddy the waters. Tett suggests that the root cause of the bond liquidity problem is the transfer of bonds from the dealing desks of the City (2007 USD418 billion, 2020 USD60 billion) to the fund managers that issue Corporate Bond ETFs that have seen an additional USD500 billion in assets.
Given the estimated size of the Fixed Income market of USD100 trillion, it is hardly convincing. What drew the ire of the Cassandras, who had always suggested there was going to be a problem at the height of the March crisis, was the fact that Corporate Bond ETFs traded with a discount of 5 per cent to the theoretical NAV.
By comparison I note that the Dow Jones Stoxx 600 Banks index is down 37.5 per cent at the mid-way point of 2020, whereas as an asset class Euro Corporates are just about flat for the year. Corporate bond index trackers are simply not as risky as mainstream equity trackers. Shouldn’t more journalists be concerned why the banking sector might truly be at risk?