Has the bond ETF boom helped nurture the private credit frenzy?

A lot of people viscerally hate the idea of fixed income ETFs, but despite the recent choppiness in bond markets ETFs keep going, growing and altering the nature of the underlying market.

The rising popularity of corporate bond ETFs — and the portfolio trading that they help enable — makes it easier for investors to manage portfolios, lowers trading costs and increases liquidity, according to a new Barclays report.

This has major implications. Barclays argues that ETFs have dramatically lowered the “liquidity risk premium” — the extra returns that investors demand to compensate for owning less-liquid securities — and led to lower yields across the entire market for US junk bonds.

From the report, written by head of research Jeff Meli, with Alphaville’s emphasis:

— New products and protocols in the high yield (HY) corporate bond market — ETFs and portfolio trading, in particular — have improved investors’ ability to manage their trading needs at a lower cost.

— A consequence of this improvement is that the HY liquidity risk premium (LRP) has declined since 2019, both relative to other asset classes and within the HY market itself. This decline has coincided with both the increased use of ETFs and the advent of portfolio trading. We estimate that the yield on HY debt is 50-100bp less than it would have been absent these improvements in liquidity management, after accounting for the level of interest rates, the spread of IG credit, and the ratings composition of the HY market.

— Within the HY market, the difference between the yield of bonds with the lowest and highest liquidity, adjusted for downgrade, interest rate and default risk, has fallen by 30-40% since 2019. We attribute this decline to the flattening of the positive relationship between yields and illiquidity. In the past, HY corporate bond yields increased monotonically as liquidity declined. However, this relationship has changed recently, and bonds with medium liquidity have virtually the same yield as bonds with the worst liquidity. This suggests that the decline in the LRP does not reflect the aggregate level of HY yields, but instead is linked to structural changes in how investors source and access liquidity. Consistent with this explanation, the HY market’s currently elevated yields have not been seen since the 2015/2016 energy crisis, when the LRP accounted for 35% of the HY index yield vs only 17% currently.

A 100-basis-point secular decline in average yields is pretty dramatic. It’s far more than you’d expect from a one-notch credit rating upgrade or downgrade, for example.

And notably, Meli also argues that the erosion of the liquidity-risk premium — and the resulting decline in the return potential of the high-yield bond market in general — is probably driving the increasingly ravenous appetite for untraded private credit.

From the report:

Our analysis has important distributional implications for investors depending on their demand for liquidity and their investment strategies. Active managers, such as HY mutual funds, which must meet daily redemptions and so must trade a lot, have benefited from improved ways to manage liquidity. Further, active managers’ performance is evaluated against their ability to consistently outperform their benchmark. While the reduction in benchmark yields (due to the lower LRP) is not relevant for their relative performance metrics, the reduced transaction costs allow active managers the space to use their expert knowledge to generate alpha, which in principle should attract more interest to their funds.

On the other hand, a declining liquidity risk premium has likely made asset allocators, such as insurers and pension funds, worse off. These buy-and-hold investors do not manage daily liquidity needs and are far less sensitive to the liquidity of their bond holdings than mutual funds. Hence, investing in the illiquid HY market provides an attractive, and yet relatively risk-free way, to generate extra returns for these type of investors.

As the rewards of investing in HY decline, it is possible that investors have tilted portfolios towards other asset classes offering more attractive investment opportunities — such as private credit . . . According to Preqin Pro data, an increasing number of pension funds have added private credit as an asset class over the last three years, and asset allocations for those (ie, pension funds that invest in private credit) have nearly doubled — from 3.0% to 5.7%. Similarly, insurers continue to increase the share of private credit in their bond portfolios.

While the rise of private credit likely has many causes, we believe that the combination of the high return hurdles for asset allocators and the lack of viable alternatives has been an important contributing factor. Moreover, this source of demand for private credit is structural and less sensitive to the level of interest rates or macroeconomic conditions, and as such, is likely to be stable through the economic cycle.

Intriguing as the argument is, this seems like a bit of a stretch.

Yes, the rising interest in private credit has been driven by the higher (and seemingly smoother) returns on offer compared to public debt markets. But it seems more like the insane appetite for private credit has lowered its own liquidity risk premium to minimal levels. Investors simply seem to be paying up for the privilege of avoiding mark-to-market accounting, rather than being turned off by the theory that prospective junk bond returns have faded.

Still, it’s possible that the broad yield erosion identified by Barclays is helping stoke the private credit boom on the margins. And hey — it’s a good argument for pension fund CIOs to make when they argue for increasing their private capital allocations.

Further reading:

— The private credit ‘golden moment’
— Bond portfolio trades are cheap as chips. Why?
— High yield ETF influence on underlying bond market jumps
— The creeping equitisation of credit trading