THIS ARTICLE IS QUOTED FROM ZEROHEDGE.COM. THE LINK IS AS FOLLOWS:
http://www.zerohedge.com/news/2015-...f-holders-sold-all-once-howard-marks-explains
Submitted by Tyler Durden on 03/26/2015 15:24 -0400
The realization that there is, as of this moment, at best negligible and very often zero liquidity in bonds (or even stocks) is known by most: a topic we first discussed back in the summer of 2013 (a good place to start is Phantom Markets: Why The TBAC Is Suddenly Very Worried About Market Liquidity) has become so pervasive that even the BIS admitted last week bond market liquidity has cratered, with some estimates suggesting that corporate bond liquidity is down 90% since Lehman, mostly thanks to central banks' unprecedented absorption of some $5 trillion in "high quality collateral" from the private market.
In fact, moments ago the head of the Bank of England himself, Mark Carney, warned about the risk of "disorderly unwinding of portfolios" due to the lack of market liquidity.
"Market adjustments to date have occurred without significant stress. However the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia," Carney told a news conference after a meeting of the FSB.
"As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets."
Liquidity, which is increasingly synonymous with the inverse of Fed counterparty risk because in a world in which the Fed has onboarded virtually all risk, there is no need for market-making since only buying is encouraged and any concentrated selling leads to an immediate market break, has become such a buzzword, it is the topic of Howard Marks' latest letter.
We will skip the big picture of Marks' observations on how we have reached this sad state and what will eventually happen in a market devoid of liquidity, as most of it has been covered before, but we will focus on what Howard Marks thinks will happen in a far more murky and misunderstood aspect of modern markets: the synthesis between ETFs and underlying securities. Because while nobody doubts that liquidity in underlying cash instruments has rarely been worse, this is offset by substantially better liquidity in the ETF space if only superficially, thereby allowing amateur "analysts" to disregard the reality of systemic liquidity shortages and focus on what the red pill reveals: why, just look at how liquid the JNK is.
Well, no. This is what Howard Marks thinks about ETFs and the phantom liquidity impression they create. For the impatient ones, here is a spoiler alert: think Auction Rate Securities.
ETF-like vehicles, sometimes known as “tracking shares,” began to appear in the early 1990s, and they proliferated significantly after 2000. According to Wikipedia, “As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.” (Several years ago I cited Wikipedia in a memo, and Oaktree co-founder Richard Masson – a stickler for correctness – told me in no uncertain terms that it wasn’t a respectable source. I think things have changed enough since then, Richard: I’m citing it!)
ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity?
Here’s what Wikipedia has to say about the liquidity of ETFs:
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. . . .
Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell. Their actions theoretically could cause the trading price of the ETF to diverge from the value of the securities in the underlying portfolio. To minimize that risk, the creators of ETFs established a mechanism through which financial institutions can trade in wholesale quantities of “creation units” of the fund at NAV.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.
If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.
What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.
This whole discussion calls to mind a Wall Street Wonder called “auction rate securities.” They were popular ten years ago, but today they’re only a footnote to financial history. In brief, auction rate securities were developed to satisfy the desire of borrowers for long-term financing at the lower interest rates on short-term debt. The securities were described as safe and liquid because Dutch auctions would be held every week or month, resetting the yield on the securities to contemporary levels and thereby ensuring a price near par, as well as plentiful liquidity. Certainly there would always be some yield capable of enticing investors to buy at par. Thus the securities would be free from the risks associated with long-term debt. That’s what should have happened. Here’s what Wikipedia says did happen:
http://www.zerohedge.com/news/2015-...f-holders-sold-all-once-howard-marks-explains
Submitted by Tyler Durden on 03/26/2015 15:24 -0400
The realization that there is, as of this moment, at best negligible and very often zero liquidity in bonds (or even stocks) is known by most: a topic we first discussed back in the summer of 2013 (a good place to start is Phantom Markets: Why The TBAC Is Suddenly Very Worried About Market Liquidity) has become so pervasive that even the BIS admitted last week bond market liquidity has cratered, with some estimates suggesting that corporate bond liquidity is down 90% since Lehman, mostly thanks to central banks' unprecedented absorption of some $5 trillion in "high quality collateral" from the private market.
In fact, moments ago the head of the Bank of England himself, Mark Carney, warned about the risk of "disorderly unwinding of portfolios" due to the lack of market liquidity.
"Market adjustments to date have occurred without significant stress. However the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia," Carney told a news conference after a meeting of the FSB.
"As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets."
Liquidity, which is increasingly synonymous with the inverse of Fed counterparty risk because in a world in which the Fed has onboarded virtually all risk, there is no need for market-making since only buying is encouraged and any concentrated selling leads to an immediate market break, has become such a buzzword, it is the topic of Howard Marks' latest letter.
We will skip the big picture of Marks' observations on how we have reached this sad state and what will eventually happen in a market devoid of liquidity, as most of it has been covered before, but we will focus on what Howard Marks thinks will happen in a far more murky and misunderstood aspect of modern markets: the synthesis between ETFs and underlying securities. Because while nobody doubts that liquidity in underlying cash instruments has rarely been worse, this is offset by substantially better liquidity in the ETF space if only superficially, thereby allowing amateur "analysts" to disregard the reality of systemic liquidity shortages and focus on what the red pill reveals: why, just look at how liquid the JNK is.
Well, no. This is what Howard Marks thinks about ETFs and the phantom liquidity impression they create. For the impatient ones, here is a spoiler alert: think Auction Rate Securities.
ETF-like vehicles, sometimes known as “tracking shares,” began to appear in the early 1990s, and they proliferated significantly after 2000. According to Wikipedia, “As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.” (Several years ago I cited Wikipedia in a memo, and Oaktree co-founder Richard Masson – a stickler for correctness – told me in no uncertain terms that it wasn’t a respectable source. I think things have changed enough since then, Richard: I’m citing it!)
ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity?
Here’s what Wikipedia has to say about the liquidity of ETFs:
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. . . .
Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell. Their actions theoretically could cause the trading price of the ETF to diverge from the value of the securities in the underlying portfolio. To minimize that risk, the creators of ETFs established a mechanism through which financial institutions can trade in wholesale quantities of “creation units” of the fund at NAV.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.
If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.
What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.
This whole discussion calls to mind a Wall Street Wonder called “auction rate securities.” They were popular ten years ago, but today they’re only a footnote to financial history. In brief, auction rate securities were developed to satisfy the desire of borrowers for long-term financing at the lower interest rates on short-term debt. The securities were described as safe and liquid because Dutch auctions would be held every week or month, resetting the yield on the securities to contemporary levels and thereby ensuring a price near par, as well as plentiful liquidity. Certainly there would always be some yield capable of enticing investors to buy at par. Thus the securities would be free from the risks associated with long-term debt. That’s what should have happened. Here’s what Wikipedia says did happen: