Concentration risk on the customer side of credit markets: The causes

Central banks took an enormous step towards direct market intervention in 2020. All central banks in developed countries expanded their quantitative easing (QE) programs to incorporate direct purchases of corporate bonds. As of December 31, 2020, the European Central Bank (ECB) and the US Federal Reserve held €250 billion and €46 billion value of corporate bonds on their balance sheets, respectively.

Although these holdings are usually not as massive as the whole national debt, the way in which the Fed carried out this monetary policy intervention was quite novel. It bought almost 6% of the whole assets under management (AUM) in exchange-traded funds (ETFs) for US corporate bonds and outsourced execution to BlackRock.

This was just the most recent example of how participants on the buy-side credit market have evolved because the global financial crisis. Over the past decade, the buy-side structure has grow to be highly concentrated, a lot in order that today the world’s five largest asset management firms own greater than 27% of worldwide credit AUM.

At the identical time, regulators’ efforts to curb excessive risk-taking by financial intermediaries have limited their ability to offer liquidity to the market. At the identical time, low rates of interest and central bank bond purchases have boosted corporate bond issuance, making the necessity for liquidity facilities more necessary than ever.

For this reason, many market participants have turned to ETFs. Why? Because they imagine that ETFs – as intraday-traded instruments that put money into many indexed securities – can provide another source of liquidity.

This considering is wrong. Investments in these securities have significantly increased the importance of ETFs available in the market and established a brand new style of large and necessary buy-side investor in the shape of the ETF sponsor. However, this investor may not have the identical investment objectives or incentives as their traditional buy-side counterparts.

Structure of the buy side of the company bond market

For a few years, credit markets have been notoriously exposed to issuer concentration risk. The investment grade (IG) financial sector and the high yield (HY) energy sector represent 15% and greater than 20% of the chance of every of those markets globally, respectively.

While the issuer perspective is crucial for risk assessment, investors also needs to consider the buy side of the market.

The current buy-side structure of the worldwide bond market is difficult to explain objectively. Bonds are sometimes held directly by non-financial firms or by liability-oriented investors who don’t all the time publicly report all of their holdings. For example, data from the Fed’s Flow of Funds show that mutual funds account for nearly 30% of corporate and foreign fixed-income assets held by U.S. firms. Insurance firms are the biggest owners of those assets, accounting for 37.5% of the whole as of December 31, 2020.

This explains why the impact of buy-side concentration and its consequences for the structure of the company bond market have thus far been largely ignored.

To assess these trends, we used Bloomberg data to create an aggregated view of all investment firms that advise or directly hold securities included within the ICE-BofA Global Corporate and HY indices. This universe of two,847 investment management firms covers 33% of the whole global IG and 41% of the worldwide HY indices. Our evaluation confirmed significant concentration on the investor side: 45% of the IG and 50% of the HY markets are held by the ten largest investment firms.

What explains this increased concentration? The mutual fund universe offers some insight. Mutual funds are probably the most actively traded buy-side investments and permit for more in-depth evaluation attributable to their greater availability. However, corporate bonds are suitable investments for a lot of other fixed income strategies, so the universe must be considered beyond corporate bond-focused mutual funds. For completeness, we’ve included so-called “aggregate” strategies in our evaluation along with corporate bond-focused strategies.

The following chart illustrates the extent of concentration on the buy side: the three largest asset management firms represent 28% of assets under management, while 90% of corporate bond ETF assets are managed by just three firms.

AUM concentration amongst management firms by fund type

The role of passive investing within the bond markets

Regardless of 1’s attitude towards passive investing or ETFs as an investment vehicle, this market currently operates in an oligopolistic structure with potential implications for pricing, liquidity and your entire energetic management industry.

While the ETF sector’s share of the mutual fund industry’s total assets under management had already begun to rise before the worldwide financial crisis, this increase accelerated significantly within the wake of the crisis. Although ETFs account for 9% of all funds in our evaluation (including so-called aggregate strategies), greater than 25% of IG-focused corporate investment funds are invested via ETFs, as are only over 12% of high-yield bond-focused funds.

Share of passive funds (ETFs) in fixed-income investment fund universes by strategy

The rise of ETF investments in the company bond market is basically attributable to ETFs’ ability to efficiently track broad indices and their nature as exchange-traded securities. The latter feature mitigates price transparency issues and makes the safety accessible to a big selection of investors.

Since the worldwide financial crisis and the next regulatory restrictions on financial institutions, ETFs have grow to be the principal liquid instruments for various investors to administer their credit risk. Even more impressive is the share of ETFs within the inflows into or out of the asset class: during the last three to 5 years, ETFs have accounted for nearly 50% of inflows into IG corporate funds and 30% into HY funds.

ETF share of inflows into USD bond funds

The Fed’s decision to incorporate these instruments in its pandemic-related QE programs reflects this reality: the liquidity of corporate bonds is determined by ETF trading conditions.

However, an evaluation of the US equity and glued income ETF universes shows that this assumption isn’t entirely true. With the exception of probably the most liquid decile of presidency bond funds, fixed income ETFs seem like two to 5 times less liquid than their equity counterparts. This is one other explanation for the necessity for the Fed’s intervention in the company bond market in 2020.

Maximum discount to net asset value for US-listed ETFs, average by decile, December 2019 to December 2020

Extreme market conditions comparable to the March 2020 crisis remind us that while ETFs are exchange-traded instruments, this alone is not any guarantee that the underlying securities are resistant to liquidity stress. On the contrary, the high concentration amongst ETF providers – amongst ETF replication algorithms – also tends to pay attention trading pressure on certain bonds. These are traded more continuously and cause more volatility in addition to higher liquidity costs when ETFs come under selling pressure.

Of course, ETF instruments are usually not without costs for investors. The most neglected are the final premiums for ETF bonds and the issuer risk concentrations inherent within the underlying debt-weighted corporate bond indices. For these reasons, corporate bond ETFs don’t capture the complete market risk premium over the long run.

Against this background, the oligopolistic market structure that has emerged attributable to the influence of ETFs should be taken under consideration.

In the second a part of our evaluation, we explain what impact this has on investors who need to generate alpha within the bond markets and thus also on portfolio construction itself.

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