Lack of liquidity in the bond market could hit fixed-income ETFs particularly hard when interest rates rise, argued the chief investment strategist for Credit Suisse Private Banking Americas.
In part, she blamed the increased regulatory burden on market participants that is restricting their ability to provide liquidity to an already thin market; when interest rates rise, and holders of bond funds head to the exits, the fear is there won't be anyone there to pick up the slack.
“There’s a growing concern that the lack of dealer liquidity that has been put upon us because of the heavy regulation is going to be a big problem, especially in specific corners of the credit market,” Barbara Reinhard told the crowd at a recent summit put on by the Financial Planning Association's New York regional chapter. “There’s a real gumming up of the pipes as a result of Basel III, as a result of impending Dodd-Frank...and that’s causing a very big problem for the financial community and there will be a blowup at some point.”
And where will the impact be felt most? “My big fear is that it will be in the fixed-income ETFs,” she says. The ability to trade the funds easily may result in too many investors selling when interest rates rise; but on any given day, only 10 percent of the ETF's holdings are actually tradable, she said. “That’s going to be a day of reckoning that’s going to be coming,” Reinhard says.
“That’s where you always get a squeeze,” Reinhard says, suggesting that they may have to go out and sell futures because they can’t sell the underlying securities. But there’s going to be limits on how much they can actually do.
Milton Ezrati, partner and senior economist and market strategist at Lord, Abbett & Co., remains optimistic that a solution will appear prior to a crisis. A lot of the active traders in the equity market are realizing that the bond market is going to lack this liquidity and there is a lot of technological effort to put buyers and sellers together without having the intermediaries willing to take it on their balance sheet. “It hasn’t worked yet, but we have a great deal of technology looking to solve this problem,” he says.