Mom And Pop “Will Probably Get Trampled”: Alliance Bernstein Warns On Bond ETF Armageddon

Right up until China threw the financial world into a frenzy by devaluing the yuan right smack in the middle of a stock market meltdown that Beijing was struggling to contain, bond market liquidity was all anyone wanted to talk about.

Of course we’ve been talking about it for years (literally), as have a few of the sellside’s sharper strategists, but earlier this year the mainstream financial news media caught on, followed in short order by the rest of the Wall Street penguin brigade, and before you knew it, even the likes of Jamie Dimon were shouting from the rooftops about illiquid corporate credit markets.

The problem, in short, is that the post-crisis regulatory regime has made dealers less willing to warehouse bonds, leading to lower average trade sizes, sharply lower turnover, and a generalized lack of market depth. That in turn, means that trading in size without triggering some kind of dramatic move in prices is more difficult.

But that’s not the end of the story.

Seven years of ZIRP have i) herded yield-starved investors into riskier assets, and ii) encouraged corporates to take advantage of voracious demand and low borrowing costs by issuing more debt. The rapid proliferation of ETFs and esoteric bond funds has encouraged this phenomenon by giving investors easier access to corners of the bond market where they might normally have never dared to tread. These vehicles have also given investors the illusion of liquidity.

Ultimately then, the picture that emerges is of an increasingly crowded theatre (lots of IG and HY supply and plenty of demand) with an ever smaller exit (dealers increasingly unlikely to inventory bonds in a pinch).

With that as the backdrop, we bring you the following excerpts from a new paper by Alliance Bernstein:

We agree that low liquidity is a risk—but by focusing on regulations, we

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