institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

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institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Wed Jan 11, 2017 9:26 am

http://www.etf.com/sections/index-investor-corner/swedroe-sell-herding-corporate-bonds

this is a much underappreciated issue IMO as one of the consequences of the Dodd Frank bill has been a severe drying up of liquidity in corporate bonds and muni bonds as well. Dealers just don't hold much inventory so markets are thin, spreads wider (making patient trading more important) and subject to problems in flights to liquidity

Hope you find this helpful
Larry

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby livesoft » Wed Jan 11, 2017 9:34 am

So instead of avoiding corporate bonds, why not buy them when there is sell herding and the pricing is anomalouly low? Then sell them in the calm that occurs later? It reads like a free lunch to me because of some behaviors of the herds.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Wed Jan 11, 2017 10:51 am

livesoft
First, I would avoid them completely anyway for reasons I have written about in past. So you'd still be holding an asset that IMO there isn't good reason to hold anyway.
Second, I'm sure there will be some players who will do exactly what you suggest, especially if they need to rebalance anyway, they can be providers of liquidity when there are flights to liquidity and market impact costs are high. But better be an institutional player here.
Larry

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby nisiprius » Wed Jan 11, 2017 2:35 pm

I don't understand why we would beware ETFs and and not beware of mutual funds as well. Mutual funds are required to provide daily liquidity, and if they provide liquidity while investing in illiquid assets, sooner or later there will be a problem. The problem actually occurred in Third Avenue Focussed Credit; obviously, there's a huge difference between ordinary investment-grade corporate bonds and the worse-than-junk bonds Third Avenue invested in, but concerns about corporate bond liquidity were serious enough to make the SEC issue new regulations about bond mutual funds. Maybe that's fixed the problem.

Once again, plain old Vanguard Total Bond Index Fund seems to come off as a reasonable choice, and I don't understand why it gets so many knocks. It is only 28% corporate bonds. Larry Swedroe would prefer none at all, John C. Bogle would prefer more, I'm happy to just shrug and take what the market gives--to be clear, "the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market" (Barclay's words).
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Wed Jan 11, 2017 3:36 pm

Nisiprius
I agree that this can be an issue as well with funds, especially if you have forced redemptions and sales must be made at time of high cost of liquidity. Most investors have no clue how much liquidity has been impacted by Dodd Frank, an unintended consequence. This is true in munis as well as corporates.

But with ETFs the problem is that people don't understand the lack of liquidity when the ETFs themselves appear to be liquid with thin trading costs. That could quickly become an illusion as the liquidity isn't there in the underlying assets.

And note the lower the credit rating the bigger the liquidity issue becomes.

Larry

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby nedsaid » Wed Jan 11, 2017 3:53 pm

There is a larger issue of lack of liquidity in many parts of the bond market. Dodd-Frank has helped create what could be a big problem in time of crisis, that is lack of liquidity. The phrase unintended consequences comes up again and again.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Lieutenant.Columbo » Wed Jan 11, 2017 4:11 pm

larryswedroe wrote:...liquidity has been impacted by Dodd Frank, an unintended consequence. This is true in munis as well as corporates....
Larry,
does this mean one should avoid also municipal bonds, and not only corporate bonds? if so, what reasonable options is the investor left with as far as fixed income?
thank you
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby lack_ey » Wed Jan 11, 2017 4:27 pm

I'm pretty sure Larry would effectively say that

1. As stated before, there is less of an effect in the high quality parts of the market. He prefers keeping to the safest muni bonds, like AAA/AA-rated general obligation and essential services—furthermore excluding some states—which historically are rock solid. (If anything this is what people de-risk into, not out of.)

2. Price dislocations on the downside and liquidity don't really matter if you're not selling. If you're running a bond ladder—like his firm runs—some issues will come due regularly and that's how you get your money. At maturity you get the par value and sidestep any potential problems in the market. Also, you probably don't keep 100% of your fixed income in any given category where there may be issues.

3. As a DIY retail investor, if you don't have the assets/time/expertise to make muni bond ladders feasible, Vanguard's muni funds are relatively high quality and not as much impacted. As an alternative, Baird Quality Intermediate Municipal Bond (BMBIX) is higher quality.

4. Depending on tax brackets and state taxes, sometimes CDs even on an after-tax basis may be competitive and worthwhile, and are safe under FDIC insurance limits. That said, currently good CD/Treasury spreads are not as great as some other times, and muni bond yields are also pretty high relative to Treasuries.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby jalbert » Wed Jan 11, 2017 4:50 pm

ETF liquidity is more problematic than mutual fund liquidity because there not only is illiquidity of the assets held to worry about, but also the bid-ask spread of the ETF shares themselves, which are unlikely to be more liquid than the bonds they hold. Also, mutual funds usually hold a small cash position to increase liquidity and reduce transaction cost of withdrawals.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Tanelorn » Wed Jan 11, 2017 5:10 pm

Maybe this is an argument for a mixed asset bond fund, ala Total Bond, rather than pure funds like Treasuries, Corporates, High Yield, MBS, etc. If you hit a liquidity crisis, your managers can always sell the treasuries first and not get stopped out at bad prices by redemptions. Of course like any bank, it only lasts if the run on the fund isn't too bad, but having a more diversified asset mix and the kind of investors who own those probably makes you less prone to panics than investing in the Third Avenue equivalent of very junky high yield.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby scotbogle » Wed Jan 11, 2017 5:44 pm

Larry,

Thanks for the good article !

What do you recommend for the bond portion of the portfolio of an European investor ? Worldwide Government bonds ?

Thanks !

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Theoretical » Wed Jan 11, 2017 6:02 pm

Tanelorn wrote:Maybe this is an argument for a mixed asset bond fund, ala Total Bond, rather than pure funds like Treasuries, Corporates, High Yield, MBS, etc. If you hit a liquidity crisis, your managers can always sell the treasuries first and not get stopped out at bad prices by redemptions. Of course like any bank, it only lasts if the run on the fund isn't too bad, but having a more diversified asset mix and the kind of investors who own those probably makes you less prone to panics than investing in the Third Avenue equivalent of very junky high yield.


It'd need to be an active fund and not an index to do that, since index funds usually have to sell proportionally.

Being on the other side of these trades could be very interesting, such as when corporate, muni, or junk ETFs are trading at 5-10% discounts to NAVs on Really Bad Days could be valuable IF you are careful with limit orders and a strictly trying to harvest long-term reversals. The spreads can kill you quickly here.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Wed Jan 11, 2017 6:27 pm

Few thoughts
First, for LT. if you own individual bonds you don't have forced selling caused by others demanding liquidity. And then you can when you have cash available be a patient buyer and earn the liquidity premium. Note this is what DFA was able to do in small stocks during the bear market in 08 when it was the only equity fund family to get inflows. Same idea. And Lackey gave good answers.

Second, I've always recommended avoiding corporates but especially high yields, and if owning corporates stick to the highest quality and shorter term, where don't have much default risk and thus less equity risk and also less call risk. So for Europeans I would stick with global government high quality (not EM) bond fund.

Tanelorn, theorectical gave you a good answer. But let me give this real world example of what happens to non indexers. In the Lehman crisis Lehman couldn't sell the junk so they dumped all their TIPS which were more liquid (but not as liquid as non inflationary treasuries, so they took some hits there) and that as dumb as it sounds in a flight to quality TIPS yields went up!!! And I was pounding on the table to buy them. So opportunities can show up that are unexpected.

IMO bottom line just another reason to stick with CDs where you can for taxables.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Beliavsky » Wed Jan 11, 2017 9:58 pm

larryswedroe wrote:Few thoughts
First, for LT. if you own individual bonds you don't have forced selling caused by others demanding liquidity. And then you can when you have cash available be a patient buyer and earn the liquidity premium.

You can invest in closed-end bond funds selling at discounts for the same reason and also get a more diversified portfolio than you would from owning individual bonds. Closed-end funds that do not use leverage (many do) will not be forced sellers in a bond bear market.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Thu Jan 12, 2017 9:58 am

Beliavsky
Yes, true but then you typically are paying a high expense ratio. At times these can be attractive speculative plays when the discounts get very wide, but I would not play in that space. Again, you also have all the issues I have mentioned about why IMO no need to invest in corporates anyway
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Theoretical » Thu Jan 12, 2017 10:08 am

What about a credit barbell with Treasuries/CDs and a small slice of Fallen Angel bonds like ANGL, again with the caveats of buying/selling the ETF against the herd (or at least sideways to it)?

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby nisiprius » Thu Jan 12, 2017 11:58 am

larryswedroe wrote:...Second, I've always recommended avoiding corporates but especially high yields, and if owning corporates stick to the highest quality and shorter term, where don't have much default risk and thus less equity risk and also less call risk...
Well, this is one of the places where I get confused, myself, because I see many articles warning about "corporate bond ETFs" that turn out to be warning about high yield corporate bond ETFs, and I hardly think the two are synonymous. In my naïve way I have always said "I hold bonds for safety, not high returns; I am an investor, not a speculator; therefore obviously I want 'investment-grade' bonds."

I know that the liquidity issues with investment-grade corporates are enough that someone at Vanguard mentioned that it was getting to be harder to manage the Total Bond fund because it was no longer as simple as just buying all the issues in the index...

Anyway, the question, I have, Larry, is that, trying to put aside ideas of the optimum and just following Bogle's dictum that "Successful investing involves doing just a few things right and avoiding serious mistakes," if you look at an investment grade corporate bond ETF like the Vanguard Intermediate-Term Corporate Bond ETF--recognizing that black swan situations by definition can't be foreseen, and recognizing that bond ratings don't directly speak to liquidity--does this ETF meet your criteria of "highest quality and shorter term," or it is in a grey area?

$10 billion AUM,

Image
Type % Bonds
AAA 1.71
AA 7.90
A 36.93
BBB 53.46
BB 0.00
B 0.0
Below B 0.00
Not Rated 0.00

Here is what VCIT was doing the year of the "flash crash," in comparison with iShares iBoxx $ High Yield Corporate Bd HYG.

Image

Morningstar calls HYG "low" credit quality, gives it an average of B rather than Baa, and show this as the breakdown for HYG:

Credit Quality
Type % Bonds
AAA 1.07
AA 0.00
A 0.00
BBB 0.98
BB 50.86
B 36.51
Below B 10.59

So, VCIT is entirely "BBB and higher," while HYG is 98% "BB and lower."
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Thu Jan 12, 2017 12:35 pm

Nisiprius
I would say not on two fronts, First BBB is way too low, especially that's an average, so many will be below that. Second duration IMO is too long entailing too much credit and call risk (though that isn't much of risk today, but I'm giving general advice)

I would stick if HAD to say something like 5 year average maturity and lowest quality AA. But why bother, just own CDs or TIPS
Larry

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Thu Jan 12, 2017 12:38 pm

Theoretical
Fallen angels are the one place where credit risk has been rewarded. and that is because when something falls below investment grade all the funds and pension plans that cannot hold anything but investment grade by charter MUST SELL and you get a sharp drop in price, big market impacts can occur. And of course the early call risk goes WAY DOWN as the bond is now trading well below par likely. But to me I would much rather buy small value stocks where I get premium with far more diversification and in tax efficient way. It's basically a very similar type of equity risk embedded in those fallen angels.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby slickwillbo » Thu Jan 12, 2017 3:12 pm

Are bond ETFs really worse if you have no plans to selling the bond fund (or can sell it flexibly)?

It seems that a spike in redemptions could cause mutual funds to sell their bonds during a liquidity squeeze, hurting all investors in the fund- even those who don't sell. With an ETF, those wanting to sell during a squeeze do so on the secondary market, not causing the fund to sell underlying assets.

Is there something I'm missing?

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Doc » Fri Jan 13, 2017 6:55 am

larryswedroe wrote:Nisiprius
I would say not on two fronts, First BBB is way too low, especially that's an average, so many will be below that. Second duration IMO is too long entailing too much credit and call risk (though that isn't much of risk today, but I'm giving general advice)

I would stick if HAD to say something like 5 year average maturity and lowest quality AA. But why bother, just own CDs or TIPS
Larry

Nisiprius used Morningstar credit quality metric which uses a weighted average credit rating. The weight is related to the default rate.

That said BBB is still very low.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Tanelorn » Fri Jan 13, 2017 7:45 am

slickwillbo wrote:Are bond ETFs really worse if you have no plans to selling the bond fund (or can sell it flexibly)?

It seems that a spike in redemptions could cause mutual funds to sell their bonds during a liquidity squeeze, hurting all investors in the fund- even those who don't sell. With an ETF, those wanting to sell during a squeeze do so on the secondary market, not causing the fund to sell underlying assets.

Is there something I'm missing?

Generally I think you're right, although how exactly true this is depends on how the ETF is structured. Certainly you would expect the ETF to be selling at a discount to apparent NAV in a panic selloff with illiquid underlying assets. But that doesn't matter if you don't sell (although the discount could easily close by NAV falling rather than the market price recovering).

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Fri Jan 13, 2017 10:28 am

Note that the trading in these ETFs could become very illiquid and with pricing varying greatly from NAV as the underlying market makers back away from the markets and have to liquidate their own positions to create liquidity for themselves.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby lack_ey » Fri Jan 13, 2017 11:26 am

Still, to me "market price may be funny at times in times of market stress so you can't always get a fair price" sounds better than "other investors may screw you over by redeeming when NAV is higher than the underlying can be sold for."

Supposing you were to invest any in speculative bonds in either structure, this wouldn't be a majority of your fixed income anyway and you could meet liquidity needs with something else.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Fri Jan 13, 2017 12:48 pm

for those interested, here's a new good paper explaining the issue related to approved participants who create and redeem shares of ETFs
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2895478&download=yes

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby alex_686 » Fri Jan 13, 2017 1:17 pm

slickwillbo wrote:Are bond ETFs really worse if you have no plans to selling the bond fund (or can sell it flexibly)?

It seems that a spike in redemptions could cause mutual funds to sell their bonds during a liquidity squeeze, hurting all investors in the fund- even those who don't sell. With an ETF, those wanting to sell during a squeeze do so on the secondary market, not causing the fund to sell underlying assets.

Is there something I'm missing?


Yes, it is the way that bond indexes are constructed. Most bond indexes cover about 10% of the corporate bond market. While IBM issues only a single share class they issue dozens of bonds. When constructing a bond index only the most liquid bonds will be chosen. This has a perverse affect. Liquidity has value, so liquid bonds are priced higher, so their yield is lower. Being put on a index makes them more liquid, increasing its price. So bonds that are almost identical can have different prices.

There is evidence that semi-active management of bond funds can work. The funds chose bonds that look and act like the bonds in the index but are outside of it. I have seen studies on pension funds using this technique to beat indexes after expense.

Frank Dodd has apparently made this situation worse by making the pool of liquid bonds smaller. So even if you are not constrained by liquidity a index fund (ETF or Mutual) would have issues. They have to artificially limit themselves to a specific sub-class of bonds which will under perform the market as a whole.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby slickwillbo » Fri Jan 13, 2017 1:48 pm

alex_686 wrote:
slickwillbo wrote:Are bond ETFs really worse if you have no plans to selling the bond fund (or can sell it flexibly)?

It seems that a spike in redemptions could cause mutual funds to sell their bonds during a liquidity squeeze, hurting all investors in the fund- even those who don't sell. With an ETF, those wanting to sell during a squeeze do so on the secondary market, not causing the fund to sell underlying assets.

Is there something I'm missing?


Yes, it is the way that bond indexes are constructed. Most bond indexes cover about 10% of the corporate bond market. While IBM issues only a single share class they issue dozens of bonds. When constructing a bond index only the most liquid bonds will be chosen. This has a perverse affect. Liquidity has value, so liquid bonds are priced higher, so their yield is lower. Being put on a index makes them more liquid, increasing its price. So bonds that are almost identical can have different prices.

There is evidence that semi-active management of bond funds can work. The funds chose bonds that look and act like the bonds in the index but are outside of it. I have seen studies on pension funds using this technique to beat indexes after expense.

Frank Dodd has apparently made this situation worse by making the pool of liquid bonds smaller. So even if you are not constrained by liquidity a index fund (ETF or Mutual) would have issues. They have to artificially limit themselves to a specific sub-class of bonds which will under perform the market as a whole.


Thanks for the input, but I'm not quite sure how it's relevant to my post since I'm not specifically talking about bond indices. My question is this: If I plan on holding bonds - actively-managed or not - with no intention to sell (or can sell flexibly), why is a mutual fund better structure than an ETF?

As a long-term, flexible holder, temporary fluctuations in price from NAV won't affect me. Moreover, any investor in the fund who does want to sell when the ETF's price is less than the fund's NAV will be selling on the secondary market, not forcing the fund to sell bonds during a liquidity squeeze. It seems to me that this is actually a reason to favor ETFs if one is a long-term holder of bonds. Again, I could be missing something, but even in your scenario, it seems that a bond index ETF would be more favorable to a bond index mutual fund.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Fri Jan 13, 2017 2:29 pm

Slick
Well if NEVER going to sell any you might be okay. But say you have a bear market in equities and you need to rebalance, so you want to sell some of your ETF and it's in time of illiquidity and now it's trading well under NAV and bid-offer spreads are very wide. Or you have spending needs because you are in withdrawal phase?

IMO unless in a 401k plan where cannot buy CDs unless have access to a self directed brokerage account, I don't see the reasons to own corporate debt.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby livesoft » Fri Jan 13, 2017 2:48 pm

larryswedroe wrote:Slick
Well if NEVER going to sell any you might be okay. But say you have a bear market in equities and you need to rebalance, so you want to sell some of your ETF and it's in time of illiquidity and now it's trading well under NAV and bid-offer spreads are very wide. Or you have spending needs because you are in withdrawal phase?

In such a case, I think if one had a corporate bond fund that they were never going to sell, then they should then have a Treasury bond fund to use for those bear market rebalancing times. And one can make that an open-ended mutual fund instead of ETF, too.

Plus they can use the T-fund to buy mis-priced illiquid corporate bond ETFs.

Then, and if, liquidity is restored, one can rebalance from a corporate bond ETF back into Treasuries.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Fri Jan 13, 2017 3:02 pm

livesoft
That's an argument for owning both IF going to own corporates, though still not an argument for own corporates in the first place. (:-))

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby saltycaper » Fri Jan 13, 2017 3:06 pm

Larry:

Do you agree with the intuitive argument mentioned upthread that those who (theoretically) would never sell their corporate bond fund during a down market actually should favor ETFs and would potentially be hurt more long-term by holding mutual funds? Do you know if there has been a meaningful (il)liquidity impact on investment-grade corporate bond mutual funds forced to sell at inopportune times? Vanguard's corporate bond index funds weren't around in 2008-09 and their other corporate-bond heavy funds are active and hold some Treasurys. I've seen a lot of concern over this topic but have not come across much in the way of numbers for mutual funds. Perhaps too soon to tell? Thanks.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby alex_686 » Fri Jan 13, 2017 3:11 pm

slickwillbo wrote:My question is this: If I plan on holding bonds - actively-managed or not - with no intention to sell (or can sell flexibly), why is a mutual fund better structure than an ETF?

As a long-term, flexible holder, temporary fluctuations in price from NAV won't affect me. Moreover, any investor in the fund who does want to sell when the ETF's price is less than the fund's NAV will be selling on the secondary market, not forcing the fund to sell bonds during a liquidity squeeze. It seems to me that this is actually a reason to favor ETFs if one is a long-term holder of bonds. Again, I could be missing something, but even in your scenario, it seems that a bond index ETF would be more favorable to a bond index mutual fund.


You are focusing on a point in time. Instead look over a period of 10 years. There are known exploitable inefficiencies in the market due to the way the index is set up. Every year you have to pay for the advantages of extra liquidity even if you never buy or sell you funds, every year your return will be slightly lower then what it should be. Actively managed mutual funds can take advantage of these exploits.

Frank Dodd are making these known exploitable inefficiencies worse.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby saltycaper » Fri Jan 13, 2017 3:26 pm

alex_686 wrote:
Every year you have to pay for the advantages of extra liquidity even if you never buy or sell you funds, every year your return will be slightly lower then what it should be. Actively managed mutual funds can take advantage of these exploits.



Not arguing about the problem, but do you know of many mutual funds holding only corporate bonds with ER less than 0.10? Seems like options are 1) live with the problem for now; 2) buy a fund that includes some non-corporate bonds and potentially bonds with undesirable maturity ranges due to limited options (Vanguard Short-Term Investment-Grade, I'm looking at you); 3) buy a fund with a higher ER that might very well cost you more in fees than the managers can re-coup due to inefficiencies, not to mention introducing other facets of manager risk.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby slickwillbo » Fri Jan 13, 2017 3:47 pm

larryswedroe wrote:Slick
Well if NEVER going to sell any you might be okay. But say you have a bear market in equities and you need to rebalance, so you want to sell some of your ETF and it's in time of illiquidity and now it's trading well under NAV and bid-offer spreads are very wide. Or you have spending needs because you are in withdrawal phase?

IMO unless in a 401k plan where cannot buy CDs unless have access to a self directed brokerage account, I don't see the reasons to own corporate debt.


Thanks for the reply, Larry.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby slickwillbo » Fri Jan 13, 2017 3:56 pm

alex_686 wrote:
slickwillbo wrote:My question is this: If I plan on holding bonds - actively-managed or not - with no intention to sell (or can sell flexibly), why is a mutual fund better structure than an ETF?

As a long-term, flexible holder, temporary fluctuations in price from NAV won't affect me. Moreover, any investor in the fund who does want to sell when the ETF's price is less than the fund's NAV will be selling on the secondary market, not forcing the fund to sell bonds during a liquidity squeeze. It seems to me that this is actually a reason to favor ETFs if one is a long-term holder of bonds. Again, I could be missing something, but even in your scenario, it seems that a bond index ETF would be more favorable to a bond index mutual fund.


You are focusing on a point in time. Instead look over a period of 10 years. There are known exploitable inefficiencies in the market due to the way the index is set up. Every year you have to pay for the advantages of extra liquidity even if you never buy or sell you funds, every year your return will be slightly lower then what it should be. Actively managed mutual funds can take advantage of these exploits.

Frank Dodd are making these known exploitable inefficiencies worse.


I don't know why you keep replying to my posts- my OP didn't even include the word 'index'. I'm just interesting in the merits of the ETF vs open-end mutual fund structure for holding bonds (whether the composition of those bonds tracks an index or not). Index vs. actively managed is a different argument.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby patrick013 » Fri Jan 13, 2017 3:59 pm

Image

Here's some real figures from 1981 to 2012. The average and
maximum default rates are shown. There are some BBB that
have been overrated but how do you invest in corporate bonds
without risk and know the risk, in this view default risk rather
than liquidity risk ? Most funds exceed returns quite well of
TRSY fund returns, of course, which have basically zero risk if
held long term and sold at appropriate times.

Average Daily Trading Volume for corporate debt was 30.1 billion
in 2016 so the average investor still has liquidity, but the big program
traders could be having the problems when their repositionings
take several days or more. But we don't see or hear about those
very often. PIMCO used to get in trouble a few years back trying that
but otherwise not much word about it.
Last edited by patrick013 on Fri Jan 13, 2017 4:20 pm, edited 1 time in total.
age in bonds, buy-and-hold, 10 year business cycle

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby triceratop » Fri Jan 13, 2017 4:04 pm

saltycaper wrote:
alex_686 wrote:
Every year you have to pay for the advantages of extra liquidity even if you never buy or sell you funds, every year your return will be slightly lower then what it should be. Actively managed mutual funds can take advantage of these exploits.



Not arguing about the problem, but do you know of many mutual funds holding only corporate bonds with ER less than 0.10? Seems like options are 1) live with the problem for now; 2) buy a fund that includes some non-corporate bonds and potentially bonds with undesirable maturity ranges due to limited options (Vanguard Short-Term Investment-Grade, I'm looking at you); 3) buy a fund with a higher ER that might very well cost you more in fees than the managers can re-coup due to inefficiencies, not to mention introducing other facets of manager risk.


VICSX [Vanguard Intermediate-Term Corporate Bond Index Fund Admiral Shares] should qualify if shares are held for sufficiently many years. VLTCX and VSCSX (this one has no purchase fee), too. And that's just Vanguard. So these funds exist, but probably not in actively managed form.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby saltycaper » Fri Jan 13, 2017 4:11 pm

triceratop wrote:
VICSX [Vanguard Intermediate-Term Corporate Bond Index Fund Admiral Shares] should qualify if shares are held for sufficiently many years. VLTCX and VSCSX (this one has no purchase fee), too. And that's just Vanguard. So these funds exist, but probably not in actively managed form.


Thanks. Yeah, I left out the "active" qualifier by accident. I do use the Vanguard corporate bond index funds, which I presume suffer an unknown degree under Alex's and Larry's description of the bond world.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby triceratop » Fri Jan 13, 2017 4:15 pm

saltycaper wrote:
triceratop wrote:
VICSX [Vanguard Intermediate-Term Corporate Bond Index Fund Admiral Shares] should qualify if shares are held for sufficiently many years. VLTCX and VSCSX (this one has no purchase fee), too. And that's just Vanguard. So these funds exist, but probably not in actively managed form.


Thanks. Yeah, I left out the "active" qualifier by accident. I do use the Vanguard corporate bond index funds, which I presume suffer an unknown degree under Alex's and Larry's description of the bond world.


Yes, but it appears Larry has even acknowledged that using a mix of corporate/treasury bond ETFs is okay, allowing you to avoid the liquidity crises. Of course he also thinks that there is no point in being exposed to the default factor, but as far as a mechanism of exposure to the default factor the bond ETFs look okay.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Erwin » Fri Jan 13, 2017 4:17 pm

That is the reason that it is better to own an ETF that holds a basket of maturity defined corporate bonds, like the iShares iBonds series. They are held to maturity.
Erwin

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby saltycaper » Fri Jan 13, 2017 4:34 pm

triceratop wrote:
Yes, but it appears Larry has even acknowledged that using a mix of corporate/treasury bond ETFs is okay, allowing you to avoid the liquidity crises. Of course he also thinks that there is no point in being exposed to the default factor, but as far as a mechanism of exposure to the default factor the bond ETFs look okay.


Sorry, triceratop. I am not communicating well today. I'll attribute it to lack of sleep. :|

I own the mutual fund version of VCSH. I used to own the mutual fund version of VCIT before Larry's arguments became more compelling to me to stay short with corporates, and I now use more CDs for intermediate-term fixed income.

But, I've been wondering for some time now if and to what extent long-term holders of the mutual fund versions of Vanguard's corporate bond index funds would be hurt due potential liquidity issues, and if there's a case to be made to hold the ETF instead. Kind of ironic since many concerns about liquidity start by talking about problems with ETFs. Then my head explodes when I try to understand how Vanguard's dual fund structure plays into the equation, if at all. Judging by the differences in purchase fees between the short (0%), intermediate (0.25%), and long (1.00%) mutual funds, I presume the expected impact would differ among the funds.

I might switch to VCSH if someone could demonstrate numerically what the impact might be in the event of a 2008-09 situation, but I don't really want to switch if the impact is unlikely to be noticeable, as I have come to favor mutual funds for my Vanguard accounts, except for your points of ETF portability and tax-gain harvesting advantages.

I have contemplated using short-term investment-grade instead, but even if I accept active management and some Treasury holdings, nearly 20% in securities maturing in less than 1 year is not appealing to me, so my dislikes taken together make it a no-go.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby lack_ey » Fri Jan 13, 2017 4:46 pm

saltycaper wrote:
triceratop wrote:
Yes, but it appears Larry has even acknowledged that using a mix of corporate/treasury bond ETFs is okay, allowing you to avoid the liquidity crises. Of course he also thinks that there is no point in being exposed to the default factor, but as far as a mechanism of exposure to the default factor the bond ETFs look okay.


Sorry, triceratop. I am not communicating well today. I'll attribute it to lack of sleep. :|

I own the mutual fund version of VCSH. I used to own the mutual fund version of VCIT before Larry's arguments became more compelling to me to stay short with corporates, and I now use more CDs for intermediate-term fixed income.

But, I've been wondering for some time now if and to what extent long-term holders of the mutual fund versions of Vanguard's corporate bond index funds would be hurt due potential liquidity issues, and if there's a case to be made to hold the ETF instead. Kind of ironic since many concerns about liquidity start by talking about problems with ETFs. Then my head explodes when I try to understand how Vanguard's dual fund structure plays into the equation, if at all. Judging by the differences in purchase fees between the short (0%), intermediate (0.25%), and long (1.00%) mutual funds, I presume the expected impact would differ among the funds.

I might switch to VCSH if someone could demonstrate numerically what the impact might be in the event of a 2008-09 situation, but I don't really want to switch if the impact is unlikely to be noticeable, as I have come to favor mutual funds for my Vanguard accounts, except for your points of ETF portability and tax-gain harvesting advantages.

I have contemplated using short-term investment-grade instead, but even if I accept active management and some Treasury holdings, nearly 20% in securities maturing in less than 1 year is not appealing to me, so my dislikes taken together make it a no-go.

If you switched to the Vanguard ETF that wouldn't help as it's the same pool of assets as the mutual fund. You might actually get the worst of both worlds, getting some price dislocation in the ETF and then some assets being sold a bit below NAV suggests to handle redemptions on the mutual fund side, harming all remaining investors in the pool including those in the ETF.

That said, I would imagine Vanguard would separate out accounts for some large players wanting redemptions and/or slap on a redemption fee before it got too bad, much more than rounding error for existing investors.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby triceratop » Fri Jan 13, 2017 5:39 pm

lack_ey wrote:
saltycaper wrote:
triceratop wrote:
Yes, but it appears Larry has even acknowledged that using a mix of corporate/treasury bond ETFs is okay, allowing you to avoid the liquidity crises. Of course he also thinks that there is no point in being exposed to the default factor, but as far as a mechanism of exposure to the default factor the bond ETFs look okay.


Sorry, triceratop. I am not communicating well today. I'll attribute it to lack of sleep. :|

I own the mutual fund version of VCSH. I used to own the mutual fund version of VCIT before Larry's arguments became more compelling to me to stay short with corporates, and I now use more CDs for intermediate-term fixed income.

But, I've been wondering for some time now if and to what extent long-term holders of the mutual fund versions of Vanguard's corporate bond index funds would be hurt due potential liquidity issues, and if there's a case to be made to hold the ETF instead. Kind of ironic since many concerns about liquidity start by talking about problems with ETFs. Then my head explodes when I try to understand how Vanguard's dual fund structure plays into the equation, if at all. Judging by the differences in purchase fees between the short (0%), intermediate (0.25%), and long (1.00%) mutual funds, I presume the expected impact would differ among the funds.

I might switch to VCSH if someone could demonstrate numerically what the impact might be in the event of a 2008-09 situation, but I don't really want to switch if the impact is unlikely to be noticeable, as I have come to favor mutual funds for my Vanguard accounts, except for your points of ETF portability and tax-gain harvesting advantages.

I have contemplated using short-term investment-grade instead, but even if I accept active management and some Treasury holdings, nearly 20% in securities maturing in less than 1 year is not appealing to me, so my dislikes taken together make it a no-go.

If you switched to the Vanguard ETF that wouldn't help as it's the same pool of assets as the mutual fund. You might actually get the worst of both worlds, getting some price dislocation in the ETF and then some assets being sold a bit below NAV suggests to handle redemptions on the mutual fund side, harming all remaining investors in the pool including those in the ETF.

That said, I would imagine Vanguard would separate out accounts for some large players wanting redemptions and/or slap on a redemption fee before it got too bad, much more than rounding error for existing investors.


Right, and in practice the redemptions issue wouldn't be significant since 83% of the short-term corporate index fund is in the ETF share class anyway. For the intermediate-term corporate index fund, 90% is in the ETF share class, and 74% for long-term.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby larryswedroe » Fri Jan 13, 2017 6:09 pm

BTW- pure indexing in corporate bonds is "dumb" for variety of reasons. I'll just mention one. Say you have a Vanguard investment grade fund and a bond drops below their credit rating limit. The fund will be forced to sell that bond at exactly the same time all other funds and pension plans do and incur very large market impact costs. Now these are the very bonds that turn out to be the one place where credit risk in corporates has been well rewarded--the fallen angels. Another is they tend to buy the most liquid bonds by the issuer so you get lower yields for paying up for liquidity. But of course you have the same credit and term risk.Again, sticking with CDs IMO is a superior strategy where can access them.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby alex_686 » Fri Jan 13, 2017 6:50 pm

slickwillbo wrote:I don't know why you keep replying to my posts- my OP didn't even include the word 'index'. I'm just interesting in the merits of the ETF vs open-end mutual fund structure for holding bonds (whether the composition of those bonds tracks an index or not). Index vs. actively managed is a different argument.


You need to read the article and dig a little deeper. The big liquidity issues faced between between index mutual funds, index ETFs, and actively managed ETFs are basically the same. Herding occurs because they all have to play from the same playbook, they all have to dance to the same song. I think that the crux of the issue is here.

ETFs do have a few extra minor tricks up their sleeves. For example they can exchange bundles of securities for their shares. However this assumes a well ordered market. During the 2008 the market was not well ordered. I would doubt that in times of crisis that the markets would be well ordered. I just don't think the extra advantages of a ETF would confer that much of a advantage.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby saltycaper » Sat Jan 14, 2017 12:26 am

lack_ey wrote:
If you switched to the Vanguard ETF that wouldn't help as it's the same pool of assets as the mutual fund. You might actually get the worst of both worlds, getting some price dislocation in the ETF and then some assets being sold a bit below NAV suggests to handle redemptions on the mutual fund side, harming all remaining investors in the pool including those in the ETF.



Thanks. That makes sense.

triceratop wrote:
Right, and in practice the redemptions issue wouldn't be significant since 83% of the short-term corporate index fund is in the ETF share class anyway. For the intermediate-term corporate index fund, 90% is in the ETF share class, and 74% for long-term.


Good point. Surprised how dominant the ETF version is even for the short-term fund.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby Tanelorn » Sat Jan 14, 2017 5:04 am

Good discussion. Setting aside active management questions, I think I would rather own a corporate or muni bond ETF over a similar index bond mutual fund.

larryswedroe wrote:Note that the trading in these ETFs could become very illiquid and with pricing varying greatly from NAV as the underlying market makers back away from the markets and have to liquidate their own positions to create liquidity for themselves.

ETFs do sometimes lose liquidity. However, it seems more often those cases are technical glitches (intraday flash crash style events), separate from a full on market panic. In panics, the price may fall but the ETFs can still be quite liquid. For mutual funds, you avoid the first problem but may have liquidity / redemption problems in the latter.

I recall some muni scares where MUB and others traded at meaningful discounts to the current "NAV". However, there were plenty of shares available at a penny or two spread, so there was lots of liquidity - you just might not like the price. In situations like this, the biggest ETF basically is the market and the illiquid bonds are still catching up. However, you don't have to care much about the logistics of that since you own the ETF and the market makers and active traders have to figure out how to price it given the current state of the bond markets. Basically the ETF market is the efficient one and the bonds are the inefficient one, so it's better to be in the ETF.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby jdilla1107 » Sat Jan 14, 2017 11:08 am

slickwillbo wrote:It seems that a spike in redemptions could cause mutual funds to sell their bonds during a liquidity squeeze, hurting all investors in the fund- even those who don't sell.


I hear this over and over from smart people and I just don't understand it. Can anyone produce an example of how this would happen in a significant way?

Say a fund has two investors who buy in on the same day. The fund buys two bonds for $100. Now we have a liquidity crisis and the bonds market value is now $80. One investor sells, so one of the bonds is sold by the fund. That investor gets $80. The fund now has one bond left and the other investor still in the fund is unaffected.

Is the only way this happens from large bonds which are purchased and investors have small investments? Like a single $1m bond is purchased, there are $100k in redemptions and the fund is forced to sell the $1m bond to get $100k? If that's the case, I feel like fund management could make that pretty close to a non-issue by planning ahead.

I have challenged a number of people with financial backgrounds on this point and no one can tell me how this is an actual issue. I have concluded it's either FUD or people not thinking it through. Please provide an example of this.

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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby nisiprius » Sat Jan 14, 2017 12:41 pm

larryswedroe wrote:BTW- pure indexing in corporate bonds is "dumb" for variety of reasons. I'll just mention one. Say you have a Vanguard investment grade fund and a bond drops below their credit rating limit. The fund will be forced to sell that bond at exactly the same time all other funds and pension plans do and incur very large market impact costs. Now these are the very bonds that turn out to be the one place where credit risk in corporates has been well rewarded--the fallen angels. Another is they tend to buy the most liquid bonds by the issuer so you get lower yields for paying up for liquidity. But of course you have the same credit and term risk.
You know what? First the first time something has convinced me that it might be nice to have a total bond market fund that's really "total," i.e. includes both investment grade and junk bonds. I'm not going to act on that conviction, even though at least one ETF exists that tracks the Barclay's Universal bond index, I'll just pigheadedly/forthrightly stick with Total Bond because it's not bad, but I finally see the point.
Last edited by nisiprius on Sat Jan 14, 2017 3:26 pm, edited 1 time in total.
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Re: institutional herding in corporate bonds and liquidity issues-beware ETFs in this space

Postby nisiprius » Sat Jan 14, 2017 12:44 pm

Again, sticking with CDs IMO is a superior strategy where can access them.
I think it's really interesting that you are suggesting CDs. Again, because of inertia etc. I don't plan to act on that but it's really interesting.

Larry, how do you evaluate the risk that banks might deny early withdrawals on CDs? Such denials are almost but not quite unheard of. However, many banks have fine-print language that early withdrawal's are "at the bank's discretion" or "with the bank's permission;" Ally added such language to its CDs a couple of years ago; and many banks have fine print that says they can change the terms and conditions on e.g. 30 day's notice, with your recourse being a right to redeem the CD before the change takes effect.

My feeling is that seriously rising interest rates might prompt enough early withdrawals to be a meaningful problem for banks, and that if that happened they might start playing hardball and denying early withdrawals.

In this forum Kevin M. has suggested that CDs are still pretty good even without assuming a right to an early withdrawal.
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