Mutual funds and exchange-traded funds, or ETFs, grant easy access to virtually any market these days. They are particularly helpful when seeking exposure to lesser known emerging and frontier markets, especially emerging market bond funds.
Not only do these instruments provide diversification across geographies by investing in a single fund instead of buying several individual securities, as shown by the graph below highlighting EMLC, they also reduce transaction costs and risks associated with individual bonds.
ETFs owned a record share of the U.S. stock market at the end of the first quarter of 2017 with nearly 6 percent of total market holdings, according to analysis by Goldman Sachs.
ETFs come with an additional benefit of being traded on exchanges like equities. However, the perceived benefit of immediate liquidity for some ETFs may become elusive in case of a liquidity squeeze caused by points discussed in the previous two articles of this series.
Not so liquid
Though ETFs provide liquidity due to the fact that they are openly traded on exchanges, as securities they are susceptible to a liquidity squeeze just like any individual stock or bond.
The reason why liquidity of emerging market bond funds are particularly important to watch is because the holdings of some funds may become relatively illiquid at times.
When a redemption order comes in, a fund provider needs to sell assets in proportion of the order. However, if some of the invested papers become illiquid, then the fund house needs to sell more liquid papers in order to meet its obligation. This puts later redemptions at a disadvantage as their exit could be delayed depending on the salability of the remaining papers.
Now consider an event where redemption pressure becomes severe for an asset class. A fund with sizable assets invested in less liquid papers – which provide much higher yields and are thus found to be attractive – would find it extremely difficult to find takers for its holdings and may have to resort to selling at a less than ideal pace.
Or, in case of an open-ended mutual fund, it may have to halt redemptions completely.
This happened on December 10, 2015, when the Third Avenue Focused Credit Fund had barred sales of units completely. The majority of the papers the fund was invested in were deep in junk territory, making them exceptionally illiquid.
Emerging market bond funds
In order to ensure that liquidity does not become a concern, investors look closely at the credit maturity profile of ETFs and how it’s changing over a monthly and/or quarterly basis depending on the rebalancing frequency of the underlying index.
All the funds we had looked at an earlier series on credit quality (EMB) (VWOB) (EMLC) (LEMB) (ELD) have most of their assets invested in sovereign bonds, thus taking away worries of being invested in less liquid corporate bonds. However, investors keep tabs on the geographic allocation of fund holdings. Studying how macro events impacting the top invested countries in their funds to get a better understanding of the liquidity picture is imperative for minimizing risk.