Bond ETF Redemptions Encounter Liquidity Issues
Thursday, August 1, 2013
Charles Rotblut, CFA
AAII Journal Editor

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An ETF’s liquidity is determined by its underlying portfolio.

Liquidity and an Asset’s Attractiveness
The role liquidity plays in an investment’s market value.

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 35.6%, down 9.5 points
  Neutral: 39.4%, up 7.1 points
  Bearish: 25.0%, up 2.4 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

As if investors needed another eerie-sounding headline, the issue of bond liquidity has popped up. Recent articles in Reuters and Barron’s pointed to issues involving the exchange of bonds and ETF creation units. Though this may sound a like a technical concept, it’s one worth understanding.

Liquidity refers to how easy it is to buy and sell an asset. The greater the number of buyers and sellers, the more liquid an asset is. Selling shares of General Electric (GE) common stock is easy. Selling bonds issued by General Electric Capital Corporation is comparatively more difficult. Part of the problem, as I have discussed in this email before, is that a single company can have several bonds outstanding, each with different maturity dates, coupon rates and CUSIP numbers.

The vast number of bonds outstanding is what makes tracking bond indexes difficult. All index funds, whether they are mutual funds or exchange-traded funds (ETFs), attempt to mimic the return and risk characteristics of a specific index. Bond indexes are often criticized because of the difficulty in building a portfolio that has the same securities.

Potentially adding to the complexity of tracking bond indexes is a reduction in corporate bond inventories held by banks. Citing data from BlackRock, Reuters says banks’ corporate bond inventories have shrunk from $233 billion in 2007 to $56 billion today. At the same time, corporate bond issuance has risen as companies took advantage of record-low interest rates. Buy side firms, such as fund companies, have picked up some of the demand, but Reuters pointed to data from BlackRock showing that trading volumes are lower now relative to the total amount of debt outstanding than they were last decade.

This background will add a bit of color to the subject of in-kind redemptions. Market makers and institutional investors can put together a block of ETFs, known as creation units, and exchange them with an ETF’s sponsor. Alternatively, a market maker can put together a basket of securities matching the composition of the ETF’s portfolio and exchange that with the ETF sponsor. When the securities of the underlying index are liquid, these transactions occur in a smooth and tax-efficient manner.

Barron’s reported in this week’s issue that the bond market’s recent turbulence coincided with lower levels of liquidity for various bonds to cause some headaches. Rather than dealing in the individual securities, some broker dealers, market makers and institutional traders have opted to request that cash be included in their in-kind transactions. In other words, since the lack of liquidity made it too difficult to acquire or sell certain bonds included in an ETF’s portfolio, some traders and investors wanted to substitute the securities with the equivalent amount of cash.

Such requests, of course, create problems for fund sponsors and have the potential to worsen performance for the shareholders who own the funds in question. State Street handled the problem by shutting off cash as a replacement option, according to Barron’s. This was a good move for SPDR bond ETF shareholders, but likely created stress elsewhere in the bond market.

The problem shows the importance of understanding what you are investing in. Funds (exchange-traded, mutual and even closed-end) that target specific industries, types of securities or geographic markets have a greater chance of experiencing returns that are different from their underlying indexes or benchmarks. They may also incur higher expenses. During times of crisis, downside volatility can also worsen. The problems are not just limited to bond funds either: Stock, commodity, currency and the new breed of alternative funds can all face the same risk. It’s not that low liquidity is bad, but rather that it can lead to a greater amount of mispricing, more price volatility and higher transaction costs.

More on

The Week Ahead

Approximately 60 S&P 500 members will report their quarterly results, as earnings season shifts toward mid-cap and small-cap companies. The only Dow component scheduled to report is The Walt Disney Co. (DIS), on Tuesday.

The week’s first economic report will be the July ISM non-manufacturing index, released on Monday. Tuesday will feature July international trade data. June wholesale trade data will be released on Friday.

Several Federal Reserve officials will make public appearances. Dallas President Richard Fisher will speak on Monday, Chicago President Charles Evans will speak on Tuesday, and both Philadelphia President Charles Plosser and Cleveland President Sandra Pianalto will speak on Wednesday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year notes on Thursday.

AAII Sentiment Survey

Neutral sentiment surged to its highest level since 2005 in the latest AAII Sentiment Survey, as optimism dropped to a five-week low.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 9.5 percentage points to 35.6%. This is the first time optimism has been below 40% since June 27, 2013. The historical average is 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, spiked by 7.1 percentage points to 39.4%. This is the highest neutral sentiment has been since April 14, 2005. It is also the 10th consecutive week that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.4 percentage points to 25.0%. Though technically a five-week high, this is also the sixth time in seven weeks that pessimism is below its historical average of 30.5%.

Neutral sentiment is at the lower edge of what we consider to be unusually high levels (more than one standard deviation above average). Though the current reading shows a significant rise, it should be noted that this week is the 16th in the past 19 weeks with an above-average level of neutral sentiment. Furthermore, the drop in bullish sentiment corresponds with the volatility we have seen in the weekly survey results over the past several months.

Some individual investors are encouraged by signs of continued economic growth, sustained earnings growth and the length of the current rally. Others, however, are concerned about prevailing valuations, the slow pace of economic growth, interest rate uncertainty and a lack of progress on key issues by Washington politicians.

This week’s special question asked AAII members if they thought the market is pricing in future growth or if they think the market is detached from current economic and earnings trends. Respondents were split, with one-third saying the market is pricing in expectations of future growth and one-third saying the market is detached. Among those who thought the market was detached, several cited the weak pace of economic expansion, slow earnings growth or the Federal Reserve’s ongoing monetary stimulus as the reasons why. A small number (less than 10%) of respondents thought the market is fairly valued at current levels.

Here is a sampling of the responses:

  • “I think the economy will continue to improve over the next several months and the stock market will also go up.”
  • “I think the increase in P/E ratios reflects the anticipation of future growth. The signs point to growth, but not exuberant growth.”
  • “The market is detached from the actual economic and earnings trends, and is relying considerably on the actions of the Federal Reserve.”
  • “I think the market is going up despite the fact that earnings are not. Investors are overly optimistic.”
  • “The market is fairly valued now and won’t go anywhere without more profits.”

» Take the sentiment survey

AAII Asset Allocation Survey

July Asset Allocation Survey results:
Stocks/Stock Funds:
    65.2%, up 3.1 points
Bonds/Bond Funds:
    17.1%, down 0.1 points
    17.7%, down 3.0 points

Asset Allocation Survey details:
    32.8%, up 1.4 points
Stock Funds:
    32.4%, up 1.7 points
    3.6%, down 0.1 points
Bond Funds:
    13.4%, down 0.1 points

Take the survey »

A decline in bond and bond fund holdings put fixed-income allocations at their lowest level since June 2009, according to the July AAII Asset Allocation Survey. Equity allocations increased as individual investors shifted money out of cash.

Stock and stock fund allocations rebounded by 3.1 percentage points to 65.2%, matching May's levels. Equity allocations have now been above their historical average of 60% for four consecutive months and six out of the past seven months.

Bond and bond fund allocations declined 0.1 percentage points to 17.1%. This was the smallest allocation to bonds since June 2009. Nonetheless, fixed-income allocations were above their historical average of 16% for the 49th consecutive month.

Cash allocations pulled back by 3.0 percentage points to 17.7%. July was the 20th consecutive month with cash allocations below their historical average of 24%.

A rebound in stock prices and new record highs for the S&P 500 caused individual investors to view equities more favorably, at least from a short-term standpoint. On the fixed-income side, despite industry reports of continued outflows from bond funds, AAII members largely kept their allocations unchanged last month. This may reflect the long-term strategy that many of our members use to manage their portfolio allocations.

Last month’s special question asked AAII members how their allocation to emerging markets has changed this year. Slightly more than half of respondents (53%) said there was little to no change in their allocation. Included in this group are those who explicitly said they didn’t have exposure to emerging markets (about 10% of all respondents). Nearly a quarter of respondents (23%) said they either have less exposure or completely ended their emerging market exposure this year. Some respondents observed that the change in allocation was due to the comparatively stronger performance of U.S. securities (as opposed to an active decision on their part). Just 12% of respondents said they increased their emerging market exposure this year.

» Take the Asset Allocation Survey