Concentration Risk on the Buy-Side of Credit Markets: The Causes

Central banks took an enormous leap on the highway to direct market intervention in 2020. All developed market central banks added direct purchases of company bonds to their quantitative easing (QE) applications. As of 31 December 2020, the European Central Financial institution (ECB) and the US Federal Reserve held €250 billion and €46 billion in company bonds on their respective stability sheets.

Though these holdings are usually not as large as whole authorities debt, the best way the Fed performed this financial coverage intervention was relatively novel. It purchased shut to six% of the whole belongings underneath administration (AUM) in US company bond exchange-traded funds (ETFs) and outsourced the execution to BlackRock.

It was simply the newest illustration of how buy-side credit score market individuals have advanced because the world monetary disaster (GFC). During the last decade or so, the buy-side construction has grown extremely concentrated, a lot in order that at the moment the world’s high 5 asset administration companies command greater than 27% of world credit score AUM.

On the similar time, efforts by regulators to discourage extreme risk-taking by monetary intermediaries has restricted the latter’s capability to offer market liquidity. Concurrently, low rates of interest and central financial institution bond shopping for have inflated company bond issuance, making the necessity for liquidity amenities extra necessary than ever.

Consequently, many market individuals have turned to ETFs. Why? As a result of they consider that — as intra-day traded devices invested in lots of index-tracking securities — ETFs can present another supply of liquidity.

Such pondering is flawed. Funding in these securities has considerably elevated ETFs’ prominence out there and established a brand new kind of huge and necessary buy-side investor within the type of the ETF sponsor. However this investor could not have the identical funding targets or incentives as its conventional buy-side counterparts

Company Bond Market Purchase-Aspect Construction

For a few years, credit score markets have been notoriously uncovered to issuer focus danger. The Monetary sector in funding grade (IG) and the Power sector in excessive yield (HY) symbolize 15% and greater than 20%, respectively, of the chance of every of those markets globally.

However whereas the issuer perspective is essential for assessing danger, traders must also contemplate the buy-side of the market.

The worldwide bond market’s present buy-side construction is difficult to explain objectively. Bonds are generally straight held by non-financial entities or by liability-driven traders that don’t at all times report all their holdings publicly. For example, knowledge from the Fed’s Move of Funds present that funding funds whole near 30% of the company and overseas fixed-income belongings held by US entities. Insurance coverage corporations are the most important house owners of those belongings with a 37.5% share of the whole as of 31 December 2020.

This helps clarify why the consequences of buy-side focus and the implications for the company bond market construction have up to now been largely ignored.

To evaluate these traits, we used Bloomberg knowledge to construct an aggregated view of all of the funding companies advising or straight holding securities included within the ICE-BofA International Company and HY indices. This universe of two,847 funding administration corporations covers 33% of the whole world IG and 41% of the worldwide HY indices. Our evaluation confirmed a cloth focus on the investor facet: 45% of IG and 50% of HY markets are held by the highest 10 funding companies.

What explains this heightened focus? The mutual fund universe affords some perception. Mutual funds are probably the most actively traded buy-side entities and given their larger availability, they permit for extra in-depth evaluation. However company bonds are eligible investments for a lot of different fixed-income methods, so the universe past company bond-focused mutual funds should be taken under consideration. For the sake of completeness, we have now additionally included so-called “Combination” methods in our evaluation, together with company bond-focused ones.

The chart beneath highlights the extent of buy-side focus: The highest three asset administration corporations symbolize 28% of AUM, whereas 90% of company bond ETF belongings are managed by solely three corporations.

AUM Focus amongst Administration Firms by Fund Kind

Passive Investing’s Position in Bond Markets

No matter one’s perspective on passive investing or the ETF as an funding automobile, this market is presently working in an oligopolistic construction with potential impacts on worth formation, liquidity, and the energetic administration business as a complete.

Whereas the ETF sector’s share of whole mutual fund business AUM began to rise earlier than the GFC, it accelerated considerably within the aftermath of the disaster. Although ETFs quantity to 9% of the general funds in our evaluation (together with the so-called mixture methods), greater than 25% of company IG-focused mutual funds are invested via ETFs, as are barely greater than 12% of HY-focused funds.

Share of Passive Funds (ETFs) in Mounted-Revenue Mutual Fund Universes by Technique

The rise of ETF investing within the company bond market is essentially pushed by the ETF’s means to effectively replicate broad indices in addition to its exchange-traded function. The latter high quality alleviates problems with worth transparency and makes the safety accessible to a broad set of traders.

Because the GFC and the following regulatory restrictions positioned on monetary establishments, ETFs have change into the primary liquid devices accessible to numerous traders for managing credit score publicity. The ETF’s share of flows into or out of the asset class are much more spectacular: ETFs accounted for nearly 50% of inflows into IG company funds and 30% into HY over the past three to 5 years. 

ETF Share of USD Mounted-Revenue Fund Inflows

The Fed’s resolution to incorporate these devices in its pandemic-related QE applications acknowledges this actuality: The liquidity of company bonds will depend on ETF buying and selling situations.

But evaluation of the US ETF fairness and fixed-income universes exhibits this premise shouldn’t be wholly correct. Apart from probably the most liquid decile of Treasuries funds, fixed-income ETFs seem two- to five-times much less liquid than their fairness counterparts. This helps additional clarify the necessity for the Fed’s intervention within the company bond market in 2020.

Most Low cost to NAV for US-Listed ETFs, Common by Deciles, December 2019 to December 2020

Excessive market environments, comparable to that of the March 2020 disaster, remind us that whereas ETFs are exchange-traded devices, that alone doesn’t assure that the underlying securities are resistant to liquidity stress. On the contrary: The excessive focus amongst ETF suppliers — amongst ETF replication algorithms — tends to additionally focus buying and selling stress on particular bonds. These commerce extra typically and incur extra volatility in addition to increased value of liquidity when ETFs come underneath promoting stress.

After all, ETF autos are usually not with out prices for traders. Probably the most ignored amongst these are these associated to ETF bonds’ basic premium together with the issuer danger concentrations inherent in underlying debt-weighted company bond indices. For these causes, company bond ETFs don’t acquire the complete market danger premium over the long term.

Given this context, the oligopolistic market construction that has shaped because of the affect of ETFs needs to be acknowledged.

Within the second a part of our evaluation, we’ll lay out the implications this has for traders in search of to generate alpha from fixed-income markets and thus for portfolio development itself.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the writer’s employer.

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