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bryden teich

Bryden Teich is a CFA and portfolio manager at Avenue Investment Management.

How do you measure market liquidity? If you ask any trader on Bay Street, the response you get will vary depending on whether they work on an equity desk or a bond desk. Those on the equity side will tell you that liquidity has improved markedly over the past few years with the advent of high-frequency trading and other liquidity providers. If you ask someone on the bond side, they will likely tell you that liquidity is there until it isn't.

Liquidity in the bond market is often vastly misunderstood by industry regulators as well as retail private investors.

Investors who do not have extensive experience transacting in the bond market can be naive about the fact that liquidity can dry up as quickly as overnight.

Government bonds will always have their liquid markets, but corporate bonds can, at times, be very illiquid.

The Canadian exchange-traded funds (ETF) market hit a new milestone at the end of May, with assets rising above the $100-billion mark. Much of this growth has come from bond ETFs. A direct result of more investors feeling risk averse after the crisis in 2008 was a spike in demand for bond ETFs and bond mutual funds.

ETFs are meant to be passive investment vehicles that give investors the ability to track broad indexes at a low cost. However, the ETF industry has now completely morphed away from the idea of being a passive investment option.

The insatiable demand for ETFs from investors over recent years has been met by an endless supply of ETF products that have been sliced and diced by the banks and brokers.

There are now more ETFs than there are stocks on the TSX. If you own an active or leveraged ETF, you are missing the whole point about what an ETF is meant to be.

ETFs are meant to passively track an index over time through owning a basket of securities at a low cost. They are not meant to be actively managed.

In addition, the current interest-rate environment has made it harder for savers to earn even a meagre rate of return from government bonds or GICs. This has forced more and more investors into corporate bond ETFs to generate an acceptable rate of return.

These bond ETFs have created a mirage of liquidity for the corporate bond market, as individuals are able to buy and sell their bond ETFs on the stock exchange. During periods of market turmoil, the price volatility on stocks can be very high. The same can be said for ETFs. This still pales in comparison to the bond market, where much of the corporate bond universe can go no-bid, meaning there are no buyers in volatile markets.

If corporate bond ETFs are holding large quantities of bonds that cannot be priced, how can the underlying ETF be accurately priced? If a large amount of people rush to sell these ETFs at the same time and there are no willing buyers, the drop in value will be alarming. It is not implausible that some of these bond ETFs could drop 20 per cent to 30 per cent in a day during periods of turmoil in the market.

Investors in some of these bond ETFs will face a very rude awakening when the next financial panic or credit event eventually rears its head.

Regulators clamped down aggressively on the banks after the last financial crisis as they sought to make the system safer.

New regulations were aimed at making the banks stronger, forcing them to hold more equity capital and exit from some of their traditional market-making functions.

The bond trading desks at the Canadian banks have historically been liquidity providers for the corporate bond market. New regulations have made it too prohibitive and costly for the banks to maintain this function, and so they have retrenched from providing liquidity to the bond market in the same way that had historically.

At Avenue, our recent experience transacting in the bond market during the depths of the volatility in January and February only further confirmed our view that liquidity in the bond market has been completely altered by these developments.

Because of these new regulations, the system as a whole has not been made any safer, and it is a mistake to not realize that the risks have now been spread to other parts of the financial system. Regulators pushed the risk from the Canadian banks to the investment management industry and hence to individual investors who own these ETFs or investment products. The risk is now sitting in your RRSP or TFSA that own these bond ETFs.

All is not negative. There have been benefits to the growth in the ETF market, as consumers are now free to choose among a diversified group of low-cost funds.

However, despite the positives, we can't help but feel that regulators and ETF advocates have become blind to the risks that have been growing for the past several years.

When the next financial panic occurs, the only question will be how the investment industry could have missed this.