The “ETF bid” and Feedback Loops: Corporate Bond ETFs

Courtesy of Brendan Conway

They’re calling it the “ETF bid” — the idea that corporate bond prices get juiced when passively managed funds have to buy them. It’s known to happen in thinly traded stocks in some instances. So it shouldn’t come as a surprise that thinly traded, idiosyncratic markets like high-yield bonds are seeing a similar effect. It’s the cautionary part of an otherwise pretty encouraging story: ETFs’ power to crack open hard-to-reach asset classes for more investors.

This week’s print Barron’s ETF Focus on the subject concludes that investors should be especially wary of selling passively managed bond funds when markets turn bearish — that’s often the best time to buy. And investors who buy these ETFs when markets feel rosy pay a premium for the service. Obviously, it’s best to avoid paying extra if possible.

Yes, it’s the same old advice, to be a contrarian investor. But ETFs are only growing in importance in the bond markets. The more heavily they are traded, the more investors have to pay attention to their pricing dynamics — and that’s true even for those who don’t use ETFs. If you haven’t read our Barron’s print column, one of the key findings comes from Goldman Sachs’ (GS) Charles P. Himmelberg and Lotfi Karoui. The duo estimate that a monthly rebalanced portfolio of bonds tracked by the iBoxx $ Liquid Investment Grade Index, the benchmark driving the $24.5 billion iBoxx $ Investment Grade Corporate Bond Fund (LQD), has beaten comparable non-indexed bonds by roughly 4.7%, or about 1% a year, since the beginning of 2009.

Great, right? Well, not always. Index bonds also appear to sink harder during bad times, as they did late last year.

In this vein, we wanted to point out a meticulous look at how this works in practice, from TF Market Advisors’ Peter Tchir.The focus is particularly on what Tchir calls “feedback loops” that emerge when an institutional investor can’t get the price he’s seeking the corporate bond market.

In the article’s hypothetical example, the investor turns to the ETF because it’s easy to trade and can used for a variety of purposes, such as covering market risk or acting as a placeholder until the desired exposure is obtained. Others in the market interpret his late-session buying (or selling) spree as a sentiment indicator. Arbitrageurs come into play, too.

Read the whole thing here.