If corporate bond funds go into outflow prompted by a spike in yields, related ETFs could become illiquid, warns Ardea Investment Management.
Speaking to InvestorDaily, Ardea Investment Management portfolio manager Gopi Karunakaran said investors in corporate bond are not being adequately compensated for liquidity risk.
Explaining the problem, Mr Karunakaran said fixed income traders are completely reliant on banks to make markets in unlisted corporate bonds.
However, regulatory restrictions on bank proprietary trading desks and rules about leverage have “severely compromised” the ability of banks to make markets for corporate bonds on balance sheet.
"That means that liquidity in corporate bond markets has structurally become impaired,” Mr Karunakaran said.
Because credit markets have been on a bull run since 2009, the lack of liquidity has not yet been a major problem, he said.
But that could change if the corporate bonds funds go into outflow due to a spike in yields or a turn in the credit cycle, Mr Karunakaran said.
While Ardea is not predicting a rise in defaults in the near term, a rise in the risk-free rate would drive what Mr Karunakaran calls “credit tourists” back into government bonds.
“As you see [central bank] rates going up, you get money coming out of credit back into government bonds, because the yields start to get more interesting,” he said.
Rising interest rates are already testing corporate bond liquidity, he said – and by the time the credit cycle turns, there will not be enough liquidity for all investors to exit at the same time.
"That happened during the GFC – that market completely stopped. The secondary credit market completely locked up."
The “dislocation” in the corporate bond market will be most keenly felt in the ETF sector, he said.
“Corporate bond ETFs are listed instruments that promise daily liquidity on exchange to investors. But they're investing in assets that are not liquid,” Mr Karunakaran said.
"So you have this real dislocation between the liquidity that's being promised to the investor and the liquidity of the underlying asset.
"It's only if there are significant outflows that the manager of that ETF then needs to go to the market and sell bonds. And that could become a bit of a dislocation," he said.
This liquidity risk, while widely discussed, is underappreciated by market participants, Mr Karunakaran said.
The investor compensation for corporate bonds is for liquidity risk, not default risk, he said.
“And that compensation has practically disappeared – at the same time as the liquidity has actually got a lot worse. So it's not an ideal place to be at the moment,” Mr Karunakaran said.