|Corporate Bond ETF Trading Costs Rising|
|02 December, 2011|
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European investors are facing a sharp rise in costs when trading corporate bond ETFs as a result of decreasing liquidity in the underlying markets. Meanwhile, ETF investors are fleeing unsecured bank debt for safer, covered bond investments, as well as non-financial corporate bond funds, a survey by IndexUniverse.eu has revealed.
The average bid-offer spread on the London listing of iShares' Markit iBoxx Euro Corporate Bond ETF (LSE: IBCX), Europe's largest corporate bond tracker, has increased six-fold so far this year, rising from 10 basis points in January to nearly 60 basis points in September. By comparison, the fund's total expense ratio is 20 basis points a year.
Four out of five other iShares ETFs tracking euro, dollar and sterling corporate and covered bonds are also showing significant increases in dealing costs in the year to date. Only one corporate bond tracker from the firm's range, the iShares Barclays Capital Euro Corporate Bond ex-financials fund, has shown a decrease in spreads this year, apparently reflecting an inflow of investor cash to this sub-sector.
The chart above shows monthly average bid-ask spreads on six iShares corporate bond ETFs, using data provided by the issuer and the London Stock Exchange. The spread figures are based on individual "tick" data and show the average difference between the lowest ask price (best ask) and the highest bid price (best bid) as a percentage of the mid-price during the exchange's continuous trading hours.
According to one specialist ETF trader, this year's rising bid-offer spreads reflect both deteriorating liquidity in the corporate bond markets and increasingly polarised investor behaviour.
"There are basically two factors causing these widening spreads. The first is that the underlying corporate bond spreads have widened themselves; in some cases they have doubled or more. Since an ETF is only as liquid as the underlying asset class it tracks, a change in corporate bond spreads is immediately reflected in the ETF spreads as well," explained John Keogh, co-chair of SIG Susquehanna's European management committee.
"The second reason for the widening in ETF spreads is that the markets are becoming increasingly one-way; that is, we see seller-dominated markets at some times and buyer-dominated markets at others," added Keogh.
"This means that market makers may not necessarily be able to sell ETFs in the secondary market once they have bought them, and vice versa. As a result, they have to factor into their dealing spreads the potential additional costs of redeeming or creating ETF units."
In other words, market makers may be able to quote tighter spreads in active two-way markets, when the selling and buying interests are more or less in balance. During periods of market volatility, however, investors tend to buy or sell in unison for prolonged periods and ETF market makers are forced to tap into the primary market in order to balance their books. Accessing the creation and redemption mechanisms offered by ETF issuers incurs additional costs, which are then passed on to investors.
A survey of the same ETFs' assets under management over the year to date shows a substantial change in investor appetite. As a result of steadily increasing concerns over the safety of banks, investors have been selling out of corporate bond ETFs that have significant exposure to unsecured financial debt, and reinvesting both in non-financial corporate debt and in banks' covered bonds.