ETF’s “Gate” liquidity

Did fixed income ETF’s sing their swan song yesterday?  Maybe not, but after the abysmal performance yesterday, investors must reevaluate the risk and liquidity of an ETF before assuming the product is a cost-effective proxy for a diversified fixed income portfolio.  In the midst of the fixed income rout, ETF sponsors found themselves unable to absorb the selling.  The Financial Times quotes a Citi e-mail in which the trader wrote, “We are unable to take any more redemptions today…due to capital requirements we are maxed out.”  In the same article the global head of ETF capital markets at State Street was said to contact participants “to say that we were not going to do any cash redemptions today.”  While the fixed income market has been volatile over the last two days, it was not in a state of panic, and yet a number of ETF sponsor effectively “gated” redemptions.  Attached below is an excerpt from our January 2013 monthly write-up describing the risk inherent in the ETF market, and a link the Financial Times article.  Please don’t hesitate to call if you have any questions.


“As we’ve discuss on several occasions, the structure of an ETF has the potential to destailize markets should investors rush to sell.  One way to measure market liquidity is to divide the market capitalization by average daily volume, which yields the average number of days to turn over the index.  A lower turnover rate is indicative of a more liquid market.  The two largest high yield exchange-traded-funds manage a combined $27 Billion in assets, representing 468 million shares.  The daily volume for the two total 9 million shares, or 1.9% of total shares outstanding.  By comparison, 7.5% of the market capital of the S&P 500 changes hands on a daily basis.  Based on those statistics, the S&P turns over every 13.3 days, while the two largest high yield funds turn over every 52 days.  To further the point, the constituents in the S&P 500 are widely followed, actively traded companies.  The same can’t be said of a number of bonds in the high yield ETF.  The conclusion as we see it is that should an event “spook” investors, the rush for the exit is likely to worsen the selloff.”

Monthly Commentary – May 2013

The normalization of interest rates has begun.  We’ve warned for some time that Fed-engineered interest rate manipulation would result in investor losses once the central bank ended the practice.  May was the beginning of that trend.  Comments made by several members of the Federal Open Market Committee suggesting that the Fed was contemplating “tapering” the pace of their open market bond purchases was enough to panic investors into selling fixed income securities.  For the month, the price of the 10-year Treasury note fell 3.5%, while the price of the longer duration 30-year Treasury bond dropped 7.3%.  The broad market, as represented by the Barclays Aggregate Bond Index generated a loss of -1.76%.  Performing even worse, AGG, the ETF that tracks the Barclays Index, lost 2.00% for the month.


We interpret the discussion of tapering as the second of a six stage process in moving from emergency monetary accommodation to a normalized monetary/interest rate policy.  As we see it, the initial stage was the public debate among Fed officials about the need and appropriateness of quantitative easing that has been ongoing for the last twelve months.  The second stage, which began in earnest last month, witnessed consensus-like public statements from Fed members indicating that the central bank is ready to begin tapering the size of open market operations.  Prior to last month, comments by the Fed led investors to believe that such a tapering would not occur until sometime in 2014.  With the change in policy coming nearly a year sooner than was expected, the reaction was swift, as witnessed by the sharp fall in bond prices.  We expect the third stage of the process to be the instance when the Fed actually implements the tapering of bond buying, and expect details to be announced at one of the next three Federal Open Market Committee meetings.  Presumably, the Fed would want to make the announcement at a post-FOMC press conference.  Since the July meeting doesn’t end with such a conference, September is most likely, given that the June meeting is only one week away.  However, at that meeting, Chairman Bernanke is likely to face a barrage of questions about the timing and mechanics of tapering.  Once they begin the process, attention will shift to when quantitative easing ends altogether, the fourth stage.  Given the “lower for longer” interest rate philosophy of the Fed, we may not see an end to easing until the first quarter of 2014.


The final two stages of the process are raising interest rates and liquidating the portfolio of securities that they acquired over the last few years.  As a best guess, we’d look for the first rise in overnight Fed Fund rates 12 months from now, and likely in a “non-Greenspan like” one-time jump to 1%.  As for when the Fed begins liquidating the Billions of dollars of bonds bought over the last several years, we’re likely years away.


Also weighing on bond prices during the month was improving economic fundamentals.  Consumer Confidence, as measured by both the University of Michigan and the Conference Board, both reported levels that were the most optimistic since 2007.  Another encouraging sign of economic strength is the current shortage of construction workers.  The National Association of Home Builders reported that 46% of the industry has fallen behind on completions because they are unable to find enough qualified workers to complete building in time.  The Association also reports that 15% of the industry has turned down work, while another 9% had sales canceled due to construction delays.  With the prime building season upon us, the shortage is likely to result in constrained deliveries and rising home prices.  One beneficiary of the shortage is the workers themselves, as contractors report that poaching of workers at the job site has become a problem with increasing frequency.


As a consequence of rising interest rates, corporate bond issuance was up sharply in May.  In aggregate, new issue corporate paper totaled $107 Billion in May.  Despite the heightened supply, investor demand was strong, especially for the weakest credits.  J.C. Penny, the CCC-rated department store with approximately six months of operating cash on hand, marketed a floating rate loan to borrow $1.75 billion with an interest rate of 5.75% above LIBOR.  Demand was so strong that the deal was upsized to $2.25 Billion and the terms lowered to 5.125% above LIBOR.  While the collateral backing the deal, namely Real Estate, should give investors some comfort, the coupon is simply not enough to compensate for the price volatility the issue will experience if J.C. Penny files for bankruptcy sooner than is expected.  Similarly, The Republic of Italy sold $6 Billion of Euro-denominated 30-year bonds for a yield-to-maturity of 4.98%.  There were nearly $12 Billion in orders for the debt despite the fiscal issues that continue to plague the country.  As volatility returns to interest rates, we expect the demand for such lower rated credits will wane.


The foregoing discussion is for illustrative purposes only.  No Halyard client currently holds either J.C. Penny or Republic of Italy bonds, nor is Halyard making any specific recommendation of any such bonds.

Financial Times – 6/11/13

“No one wants to own Tips and the lack of Fed talk as yields have risen suggests they are letting the market feel its way,” said Michael Kastner, managing principal at Halyard Asset Management.

QE worries drive Treasury rates up

Financial Times – 6/7/13

“We are definitely worried that the market is in a cycle where selling of bonds begets more selling,” said Steven Boyd, principal at Halyard Asset Management.

The hefty outflows illustrate the anxiety of investors ahead of the May employment report due on Friday. The Federal Reserve has indicated that its suppression of interest rates under quantitative easing depends on the tone of economic data, led by the monthly jobs figures.

“‘The jobs report will be a harbinger for how bonds trade during the rest of the month,” said Mr Boyd.

Record $12.5bn outflows from bond funds

Financial Times – 5/31/13

“No one likes to see equities close at their low on a Friday as it sets the market up for an ugly open the following week,” said Michael Kastner, managing principal at Halyard Asset Management, adding that short sellers in the Treasury market were closing positions later in the day.

Markets whipsaw on Fed uncertainty