Concentration Risk on the Buy-Side of Credit Markets: The Causes

Central banks took a huge leap on the road to direct market intervention in 2020. All developed market central banks added direct purchases of corporate bonds to their quantitative easing (QE) programs. As of 31 December 2020, the European Central Bank (ECB) and the US Federal Reserve held €250 billion and €46 billion in corporate bonds on their respective balance sheets.

Although these holdings are not as massive as total government debt, the way the Fed conducted this monetary policy intervention was rather novel. It bought close to 6% of the total assets under management (AUM) in US corporate bond exchange-traded funds (ETFs) and outsourced the execution to BlackRock.

It was just the latest illustration of how buy-side credit market participants have evolved since the global financial crisis (GFC). Over the last decade or so, the buy-side structure has grown highly concentrated, so much so that today the world’s top five asset management firms command more than 27% of global credit AUM.

At the same time, efforts by regulators to discourage excessive risk-taking by financial intermediaries has limited the latter’s capacity to provide market liquidity. Simultaneously, low interest rates and central bank bond buying have inflated corporate bond issuance, making the need for liquidity facilities more important than ever.

As a result, many market participants have turned to ETFs. Why? Because they believe that — as intra-day traded instruments invested in many index-tracking securities — ETFs can provide an alternative source of liquidity.

Such thinking is flawed. Investment in these securities has substantially increased ETFs’ prominence in the market and established a new type of large and important buy-side investor in the form of the ETF sponsor. But this investor may not have the same investment objectives or incentives as its traditional buy-side counterparts

Corporate Bond Market Buy-Side Structure

For many years, credit markets have been notoriously exposed to issuer concentration risk. The Financial sector in investment grade (IG) and the Energy sector in high yield (HY) represent 15% and more than 20%, respectively, of the risk of each of these markets globally.

But while the issuer perspective is critical for assessing risk, investors should also consider the buy-side of the market.

The global bond market’s current buy-side structure is hard to describe objectively. Bonds are sometimes directly held by non-financial entities or by liability-driven investors that do not always report all their holdings publicly. As an example, data from the Fed’s Flow of Funds show that investment funds total close to 30% of the corporate and foreign fixed-income assets held by US entities. Insurance companies are the largest owners of these assets with a 37.5% share of the total as of 31 December 2020.

This helps explain why the effects of buy-side concentration and the consequences for the corporate bond market structure have so far been largely ignored.

To assess these trends, we used Bloomberg data to build an aggregated view of all the investment firms advising or directly holding securities included in the ICE-BofA Global Corporate and HY indices. This universe of 2,847 investment management companies covers 33% of the total global IG and 41% of the global HY indices. Our analysis confirmed a material concentration on the investor side: 45% of IG and 50% of HY markets are held by the top 10 investment firms.

What explains this heightened concentration? The mutual fund universe offers some insight. Mutual funds are the most actively traded buy-side entities and given their greater availability, they allow for more in-depth analysis. But corporate bonds are eligible investments for many other fixed-income strategies, so the universe beyond corporate bond-focused mutual funds must be taken into account. For the sake of completeness, we have also included so-called “Aggregate” strategies in our analysis, along with corporate bond-focused ones.

The chart below highlights the extent of buy-side concentration: The top three asset management companies represent 28% of AUM, while 90% of corporate bond ETF assets are managed by only three companies.

AUM Concentration among Management Companies by Fund Type

Passive Investing’s Role in Bond Markets

Whatever one’s perspective on passive investing or the ETF as an investment vehicle, this market is currently operating in an oligopolistic structure with potential impacts on price formation, liquidity, and the active management industry as a whole.

While the ETF sector’s share of total mutual fund industry AUM started to rise before the GFC, it accelerated significantly in the aftermath of the crisis. Though ETFs amount to 9% of the overall funds in our analysis (including the so-called aggregate strategies), more than 25% of corporate IG-focused mutual funds are invested through ETFs, as are slightly more than 12% of HY-focused funds.

Share of Passive Funds (ETFs) in Fixed-Income Mutual Fund Universes by Strategy

The rise of ETF investing in the corporate bond market is largely driven by the ETF’s ability to efficiently replicate broad indices as well as its exchange-traded feature. The latter quality alleviates issues of price transparency and makes the security accessible to a broad set of investors.

Since the GFC and the subsequent regulatory restrictions placed on financial institutions, ETFs have become the main liquid instruments available to various investors for managing credit exposure. The ETF’s share of flows into or out of the asset class are even more impressive: ETFs accounted for almost 50% of inflows into IG corporate funds and 30% into HY over the last three to five years. 

ETF Share of USD Fixed-Income Fund Inflows

The Fed’s decision to include these instruments in its pandemic-related QE programs acknowledges this reality: The liquidity of corporate bonds depends on ETF trading conditions.

Yet analysis of the US ETF equity and fixed-income universes shows this premise is not wholly accurate. With the exception of the most liquid decile of Treasuries funds, fixed-income ETFs appear two- to five-times less liquid than their equity counterparts. This helps further explain the need for the Fed’s intervention in the corporate bond market in 2020.

Maximum Discount to NAV for US-Listed ETFs, Average by Deciles, December 2019 to December 2020

Extreme market environments, such as that of the March 2020 crisis, remind us that while ETFs are exchange-traded instruments, that alone does not guarantee that the underlying securities are immune to liquidity stress. To the contrary: The high concentration among ETF providers — among ETF replication algorithms — tends to also concentrate trading pressure on specific bonds. These trade more often and incur more volatility as well as higher cost of liquidity when ETFs come under selling pressure.

Of course, ETF vehicles are not without costs for investors. The most overlooked among these are those related to ETF bonds’ general premium along with the issuer risk concentrations inherent in underlying debt-weighted corporate bond indices. For these reasons, corporate bond ETFs do not collect the full market risk premium over the long run.

Given this context, the oligopolistic market structure that has formed due to the influence of ETFs has to be acknowledged.

In the second part of our analysis, we will lay out the implications this has for investors seeking to generate alpha from fixed-income markets and thus for portfolio construction itself.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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Axel Cabrol, CFA

Axel Cabrol joined TOBAM in June 2016 as a credit portfolio manager from Butler Investment Advisory where he co-managed the WB Opportunities Fund, a long-short credit fund invested in European corporate high-yield bonds. Prior to that, he spent two years at Barep AM, managing the Barep Global Credit Fund in the same four portfolio managers team. From 2003 to 2005, he traded European government bonds at Caisse des Depots (CDC) and from 2005 IG bonds for one year. Cabrol graduated in 1999 from ENSAE (leading French engineering school) with a concentration in statistics, actuarial studies, finance, and artificial intelligence and has a post-graduate degree in statistics (with high distinction) from Université Pierre et Marie Curie, Paris VI.

Tatjana Puhan, PhD

Tatjana Puhan, PhD, is responsible for the investment management activities at TOBAM, overseeing the research and portfolio management teams. She joined TOBAM from Swiss Life Asset Managers where she was head of equity and asset allocation for third party asset management. In this role, she was responsible for a number of the company’s flagship strategies, most notably its investment solutions utilizing systematic and proprietary quantitative approaches, as well as contributing to Swiss Life Asset Managers’ asset allocation and equity research initiatives. Dr. Puhan has more than 15 years’ investment experience, worked at a number of leading asset management and private banking businesses while also bringing a strong academic and research background. Dr. Puhan holds a master’s degree in finance and business administration from the University of Hamburg and earned her PhD in finance from the Swiss Financial Institute at the University of Zurich, with research fellow appointments at the University of Zurich, Kellogg Business School (Northwestern University), and the University of Hamburg. She is a lecturer in finance at the University of Mannheim and an associated researcher of the Hamburg Financial Research Center.