Pink Elephants, Bank Runs and Bond ETFs

Pink Elephant statements are of the form “I see a Pink Elephant. Prove to me that I don’t see a Pink Elephant”. Pink Elephants are subjectively held false premises that somehow become accepted fact.

I chaired 2 sessions on Bond ETF’s last week at the WBR Fixed Income Leaders APAC seminar in Singapore. The sessions were brimming full of attendees and, to my astonishment, less than 20% of the audience had actually used an ETF. One of the ‘Pink Elephants’ about Bond ETF’s is they are illiquid during times of stress. I think this is rubbish and, on the contrary, they are more liquid than their predecessors.

Consider life before and with Bond ETFs….

Life before Bond ETFs
Unlike equities, bonds have generally been off-limits to the average man in the street. Market conventions have maintained minimum sized bond purchases at USD100,000 or more thereby excluding small investors from directly investing in the bond market. To get around this restriction the small investor focused on Bank Deposits as their fixed income vehicle of choice. Investors made a deposit and the Bank then made direct loans or bought bonds themselves to ensure that they could pay the interest and make a profit.

Thus, life before Bond ETFs was a bank intermediated world where the bond risk was borne by the bank’s balance sheet in return for a sizeable spread.
Bank portfolios are heterogeneous animals. Centuries ago, they consisted of localised lending but their risk managers learned that diversification is good and securitisation enabled concentrated risks to be diluted. But the banking community has never adopted a collective benchmark to which they gravitate, so no two banks are the same from a depositor’s standpoint and the only way of finding out about the differences is when rumours of trouble start circulating. Bank Runs are the result of this uncertainty, where depositors pull their money irrespective of the truth and the bank is forced to liquidate its holdings or seek assistance from the Central Bank.

The point is that life before Bond ETF’s was not all circuses and candy-floss…

Life with Bond ETFs
The innovation here is that now bonds trade like equities, so the little man can now buy them and the bank’s role is disintermediated. Further, the ETF’s portfolio is publicly announced and the investor bears the risk directly, which is priced in real time. There is no uncertainty surrounding a bank’s soundness since there is no bank, thereby eliminating one of the classic risks in the financial system – no more Bank Runs. Hooray!

Further still, the transparency in the ETF enables the big end of town to analyse the characteristics of the ETF (yield, duration, curve, currency, credit) directly and add this instrument to their investment universe. These institutions are motivated to buy cheap characteristics and sell expensive ones thereby becoming an active liquidity provider to the ETF world. In the pre-ETF world, these institutions would have ignored the banks completely during periods of stress, instead sitting back and watching a Bank Run unfold content that it was not their problem.

This view of the world runs contrary to the Pink Elephant.

The data seems to support a liquidity backstop for Bond ETFs

It is interesting to compare the amount of trading in the primary and secondary markets for Bond ETFs. The primary market is where the ETF manager deals directly with their Authorised Participants (APs) to create or redeem units in the ETF. The secondary market is where ETF units are exchanged between investors without affecting the ETF’s asset base. The featured image uses data from Blackrock (the operator of the Ishares ETF family) which shows that during normal market conditions only about 17% of turnover makes its way to the primary market. This number falls to less than 5% during stressed market conditions (eg Oct 2015 during the oil collapse or November 2016 when Trump was elected) which means that much more trading takes place in the secondary market when stressed. Market stress is characterised by wider discounts or premiums of the ETF’s market price relative to NAV. Wider discounts or premiums trigger pools of capital to buy or sell units cheaply to those investors seeking liquidity.

Contrary to the Pink Elephant that has somehow achieved acceptance by the broader investment community, the data suggests that Bond ETFs liquidity increases during periods of stress. This is achieved by motivating institutional pools of capital to profit from wider discounts or premia during stress.