AUCTION RATES REINCARNATE

Valuation is only a worthwhile metric in determining the price of a security when markets are functioning properly.  Well functioning markets have a combination of many buyers and many sellers, whose individually self-motivated actions lead to price discovery and liquidity.  One problem with markets is that liquidity can rapidly disappear, leaving investors holding a bag full of assets which are not worth anything near their “valuation”.  

The proliferation of ETFs has certainly increased access and liquidity in many markets, including stocks, bonds and precious metals.  This proliferation has also created a liquidity trap.  Investors have become accustomed to well functioning markets for high yield bond ETFs, wherein they are able to buy and sell diversified baskets of bonds with a single ticker on an exchange.  But can a derivative or a basket honestly offer better liquidity than the underlying assets?

In practice, we’ve seen many liquidity crises in the recent past.  The auction rate securities market, for example, seemed to provide an outsized benefit of money market like liquidity with enhanced triple-tax free yields.  Ostensibly, this was a free lunch for institutional and high net worth investors.  In terms of liquidity, there had only been 44 failed auctions between 1984 and 2007, but in the spring of 2008, the market froze.  Billions of dollars of “value” in ARS was marked down to zero on investors’ statements.  The issue was that the banks, historical buyers of last resort, had changed their behavior, and there was no one left to keep the market functioning.

So today, while the high yield bond ETF markets are functioning just fine, a major risk has developed under the surface.  Just as with ARS in 2007, confidence around liquidity has never been higher, because it has yet to be tested.  As the liquidity in the high yield bond market has rapidly declined, the liquidity mismatch between high yield bond ETFs and their underlying bonds has grown significantly.  When this ETF market’s liquidity has a hiccup, there is a chance for massive dislocation between the ETF’s NAV and the price at which it trades.

The implicit safety net would be to count on arbitrageurs to profit from the dislocation between the NAVs and market prices.  Unfortunately, this will be a difficult inefficiency to exploit, given the continued (and increasing) lack of liquidity in the underlying bonds.  Case and point, despite there being a great opportunity to exploit dislocations for convertible bond arbitrageurs in 2008, many of them instead went out of business while the securities they traded reached levels that implied worse than 100% default rates.

The point to remember is that when liquidity dries up, prices have little to do with valuation and much more to do with the price someone who is liquid is willing to pay.  Liquidity provides a much stronger hand in investing, and right now, the illusion of liquidity in high yield bond ETFs is creating a lot of weak hands who believe they are strong hands.   By the time many of them realize what they have, there is likely to be significant and permanent price impairment in their portfolios.