The rise of bond ETFs and consequent credit liquidity risk

Institutional Communication Service

One of the effects of the widespread use of Exchange Traded Funds (ETFs), the investment funds listed on the stock exchange, is the 'democratisation' of financial markets, namely because they can be bought (or sold) very easily and because they can 'replicate' complex and otherwise expensive financial instruments, thus making them accessible even to retail investors. However, the sharp rise of these instruments is raising some concerns, which have been reported by academic circles for some time. Previously, USI finance professor Francesco Franzoni had reported on the effects of ETFs on the stock price volatility (>>, followed now by Efe Çötelioğlu, PhD candidate at the USI Institute of Finance, who has published a new analysis of ETFs on bond markets.

Çötelioğlu's work, performed under the supervision of professors Francesco Franzoni and Alberto Plazzi at the USI Institute of Finance, is based on the analysis of more than 10,000 corporate bonds over the last decade, a period in which the role of ETFs in the bond market has increased significantly. The novel research shows that bonds heavily owned by ETFs exhibit stronger commonality (or correlation) in their degree of liquidity, understood as the ability of investors to liquidate positions promptly and at low cost. The fact that liquidity tends to move synchronously between bonds can reduce investors' ability to diversify this risk during times of crisis in the markets.

The study also identifies contrasting investor bases and structural differences. For example, mutual funds have “discretion” in deciding how to meet redemptions, while an ETF can’t choose which assets to sell. That means that during a market shock, fleeing investors could generate negative effects on the cost of liquidity in the market.

"Do Mutual Funds and ETFs Affect the Commonality in Liquidity of Corporate Bonds?" is the title of Cötelioglu's work, published as a Swiss Finance Institute (SFI) Reseach Paper, which has caught the attention of the financial markets community of analysts through a report by Bloomberg posted on October 14.