Bond ETFs: When liquidity isn’t an infinite resource

whirlpool waterFor institutions, the biggest pull of fixed income exchange-traded funds (ETFs) is liquidity—the ability to make a quick exit from large or small positions, without having to navigate the over-the-counter market.

Lately, however, some have been warning investors that liquidity isn’t an infinite resource, particularly when it comes to the growing world of fixed income ETFs.

A new study by Greenwich Associates finds that institutional investors are turning to bond ETFs in greater numbers as they struggle to find products in a highly challenging fixed income space.

The study finds that 59% of institutional fixed income ETF users have increased their use of bond ETFs since 2011 and 40% plan to increase their allocations in the next 12 months.

Why? Liquidity management is the top issue driving the trend—it’s the fastest growing application for ETF use. Back in 2010, only 3% of institutional investors using bond ETFs were doing so to manage liquidity. In 2014, that number jumped to a stunning 55%.

As more and more large investors pour into bond ETFs, however, the risk is that the need for speed on the liquidity front could create big waves across some of these funds. As Bloomberg reported last week, hedge fund Passport Capital, suddenly pulled its entire US$217 million stake in BlackRock’s long-term U.S. Treasuries ETF on March 31.

The ETF had become the epicentre for a major hedge fund trade according to Bloomberg, which noted the redemption was about 4% of the US$5.1 billion ETF’s assets.

Investors didn’t experience any major waves or fallout—but it does show the increasing impact institutional investors are having on the ETF space, particularly as they look for cheaper and more efficient access to fixed income. As more and more large institutions turn to ETFs for daily liquidity, trades such as this could become the norm.