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The hidden risk in the corporate bond market is at a tipping point: Study

Every 1 percent investment by ETFs in a bond lowers the return of a typical bond by 5 percent to 7 percent.

FED RATE
John Zich | Bloomberg | Getty Images

Hybrid investments like corporate bonds exchange-traded funds have become a popular alternative in today's market. With their lower expenses, reduced tax distributions and greater ease of trading, they have become a go-to investment for everyone from large firms to everyday traders. However, it is important to realize that these new funds may pose a potential risk to individual investors, as well as markets and the global economy.

Corporate bond ETFs are baskets of bonds that trade on equity exchanges as a single stock. The pairing of ETFs, which can trade millions of shares a day, and corporate bonds, which may trade only a few times a month, if at all, was so unlikely when they were first introduced in 2002 that many questioned their appeal to investors and viability on the Street.

But corporate bond ETFs succeeded by combining two of the most important market developments over the past decade: the outsized growth of corporate bonds and the soaring popularity of ETFs for institutional and retail investors.

"The combination of corporate bonds and ETFs has had the unintended consequence of lowering returns for all bond investors — from large firms to individual investors to retirees."

Fueled by low interest rates, the amount of corporate debt grew to $8.2 trillion in 2015. ETFs saw their total assets grow from $65.6 billion in 2000 to $2.1 trillion in 2015. For bond ETFs, the majority of the growth has occurred following the financial crisis. In particular, since 2008, bond ETF assets have grown more than 600 percent, while the number of ETFs available holding corporate bonds has increased more than 750 percent. As of the end of January, there was $424 billion in U.S. fixed-income ETFs.

Corporate bonds are critical to the overall health of the broad economy because they are relied on by corporations to fund new projects, by insurance companies to back potential claims and by retirement accounts to generate less-risky returns and regular income. What makes this combination unlikely is the difference between the market for ETFs and the underlying bonds.

Due to the explosion of online brokerages, investors are accustomed to obtaining accurate price information and executing stock trades with just a few mouse clicks. ETFs have further simplified trading by effectively allowing investors to purchase an entire index through one stock.

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Corporate bonds do not trade on an exchange. This makes their trading a much more complex process. To determine where a bond is trading, investors must call multiple brokers to find someone willing to take the other side of the trade and the best price. As a result, the underlying corporate bond market historically has been dominated by larger, more sophisticated investors.

This unexpected match between corporate bonds and ETFs has unwrapped a difficult-to-access market for large and small investors nationwide.

Yet the contrast between the freely traded, low-cost ETFs and the obscurely traded, higher-cost corporate bonds has raised concerns. My forthcoming research at Villanova School of Business suggests that the combination of corporate bonds and ETFs has had the unintended consequence of lowering returns for all bond investors — from large firms to individual investors to retirees. This includes their retirement accounts. Specifically, the more ETFs invest in bonds, the lower the bond return. Every 1 percent investment by ETFs in a bond lowers the return of a typical bond by 5 percent to 7 percent.

Why does this matter? Because the popularity of corporate bond ETFs have continued to mount despite the serious concerns about the unknown behavior of ETFs in the next economic crisis period. Corporate bond ETFs have yet to endure a period of sustained volatility.

As the economic downturn of 2008 to 2009 demonstrated, the corporate bond market tends to freeze in periods of distress, while ETFs continue to trade freely. As the 30-year bull market in bonds potentially comes to an end with more rate hikes anticipated, investors now have the option to exit bond positions quickly using the high volumes of ETFs, an alternative not available during past bond bear markets. The availability of this new trading vehicle will raise the potential that investors may have to endure periods of increased unpredictability in the typically lower-risk corporate bond market.

ETFs can and will be an invaluable source of information on the direction and sentiment in this important market. As with all things new, particularly in financial markets, the best course of action is preparation and awareness to avoid panicked trades at market bottoms.

By Caitlin Dannhauser, professor of finance at the Villanova School of Business