A new risk in the bond market has been getting a lot of attention lately. A recent survey by Greenwich Associates i,ii of 128 U.S. institutional managers brought to light this new reality and its impact on bond ETFs.

How the Bond Market Works

Bond markets are structured differently than stock markets. Instead of trading on a centralized marketplace (the stock exchange), bonds trade through a network made up of institutions (pension funds, asset managers, insurance companies, endowments, etc.) and also of investment banks, which act as liquidity providers.

When an investment bank receives a call from an institution that want to sell a bond, it can either find a new buyer or buy the bond on its own behalf and add it to its inventory. As investment banks see regular two-way flows, they make money absorbing buy and sell orders and make a “spread,” or a sort of markup—like a retail store would do. The business of investment banks is to absorb bond surpluses or shortages over time, since buyers and sellers rarely show up at exactly the same time. This business is made even more complex by the multitude of issues traded on the market. The investment bank’s inventory plays a key role as a “buffer” in the market, smoothing out occasional imbalances between bond demand and supply.

The Perceived New Risk for Bonds

After the 2008 financial crisis, governments decided they would not bail out banks again. Since bond inventory represents a significant risk for investment banks, regulators have forced them to reduce it. But at the same time, this inventory reduction may result in an increased bond liquidity risk, that is, a greater risk that if a lot of sellers show up at the same time, with too few buyers on the other side, bond prices will drop drastically due to a temporary imbalance between supply and demand.

Is this a real risk? The study by Greenwich Associates tells us that one-third of the money managers surveyed report that trading bonds has become more challenging in the past two years. It is very plausible that bond liquidity has really declined.

The Impact of Greater Liquidity Risk on Bond ETFs

Interestingly, bond ETFs are often perceived as part of the solution to these liquidity issues. The bond ETF trading volume has grown a whopping 30% annually since 2008. Almost half (60 of 128) of the institutional investors surveyed use ETFs either as a long-term strategic investment or as a tactical, short-term portfolio adjustment tool. Among the managers already using ETFs, 24% expect to increase their use in the coming year, while the balance expect to maintain it.

Bond ETFs or Individual Bonds?

The new regulation has traded off a lower risk of investment bank bankruptcy against a greater liquidity risk in the bond market. This risk is particularly acute at times of severe imbalance (or liquidity crash): it is possible that, in that event, bond prices would swing more wildly than in the past. Only time will tell.

In the event of a liquidity crash, what is the best holding for investors: individual bonds or bond ETFs? Bond ETFs are traded on a central marketplace bringing together hundreds of buyers and sellers. In contrast, sellers of individual bonds (especially individual investors) will be at the mercy of their investment bank’s bond desk, and it is reasonable not to expect investment banks to be very accommodating at such times of stress. They will want to protect their own risk. In my view, bond ETFs have individual issues beat by a mile.

In the end, successful long-term investors should not worry much about a liquidity crash. They generally avoid joining panic-buying or -selling movements, and after the dust settles, they are unaffected by these events.

i Greenwich Associates, “Bond Market Challenges Continue to Drive Demand for Fixed-Income ETFs,” 2015.
ii This survey was sponsored by Blackrock, a major ETF manager.