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Boom time changes to market structures can turn into significant risks when there is an abrupt turn in conditions © Financial Times

The writer is managing director and deputy chief investment officer at fund manager TOBAM

The market volatility triggered by the Ukraine war is a reminder that crises can expose hidden stresses and strains that have built up over time in the financial system.

Boom time changes to market structures can turn into significant risks when there is an abrupt turn in conditions, particularly when trading liquidity dries up. In that context, investors should note one recent change to the financial plumbing of US markets.

The New York State Department of Financial Services recently decided to allow insurance companies to classify bond ETFs as individual bonds rather than equities for assessing their capital requirements to meet solvency rules.

At a first glance, this seems economically prudent. These instruments do not represent equity risk and hence it makes little sense to classify them as such. However, it is not quite accurate to see their potential risk as equal to the risk of an individual bond.

Low interest rates made companies issue record amounts of debt in the years following the financial crisis, while market makers’ risk-taking capacity was drastically reduced due to new regulations.

Investors started to use ETFs as a replacement for the lack of liquidity providers. This increased importance of ETFs created a new type of very big and important investor in the credit market: the ETF manager. The interests and investment objectives of these managers are not necessarily aligned with those of normal buyside investors.

Today, three players in the market control 90 per cent of the bond ETF market. This dominance is likely to be reinforced by the new ruling, given that the new ruling only applies to ETFs that have at least $1bn of assets under management. It will push insurers even more into the select group of very big funds run by the same asset managers.

Fixed income ETFs usually replicate indices that focus on the most liquid part of the market. What should not be forgotten, however, is that these bonds are much less liquid than equities.

This implies that passive investing in credit markets might have an adverse impact on price discovery mechanisms. Moreover, since passive managers’ one and only investment objective is to stick to index replication, they do not have the leeway to allocate away from certain issuers or risks.

The March 2020 credit market crisis was a very good illustration of the problems. It was the first real crisis in the credit market since fixed income ETFs have found a wider adoption. Bond ETFs were badly hit, suffering disproportionately.

While investment grade ETFs represented about 30 per cent of bond funds’ assets under management, roughly 50 per cent of the IG fund outflows were from ETFs, according to our calculations. In the high yield space, outflows were almost 40 per cent from ETFs though these represented less than 15 per cent of the assets under management of HY funds.

Consequently, the discounts to NAV at which fixed income ETFs traded during the March 2020 crisis were massive because a very large number of outflows hit a very specific segment of the market that started to dry out completely.

ETFs track indices that consist of bonds which actually represent the more liquid part of the market. However, if there are heavy trades on only this market segment in times of stress, it will eventually be as illiquid or even more illiquid than the rest of the market.

If central banks had not stepped in to support the financial system more generally, bond markets would have suffered but ETF investors even more so.

Moreover, given most bond ETF assets are managed by only a few providers, that implies a concentration of algorithms to replicate benchmark indices. This tends to put trading pressure even more on certain bonds. This focus on the largest bond issuers also means ETF investors do not benefit from investment across the credit market risk universe.

This means, unfortunately, that treating bond ETFs equivalent to single bond investments from a regulatory capital point of view in reality does not convey the same kind of risks nor equivalent long-term returns.

Despite the new regulation, insurance companies must consider a thorough and prudent risk assessment of these investment instruments. This is especially the case if other regulators follow the New York decision, inducing even more insurance companies to invest in bond ETFs.

Unlike in March 2020, it is not clear whether central banks will be willing and able to intervene.

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