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Is Carl Icahn Right about BlackRock and Bond ETFs?

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Carl Icahn, the billionaire activist investor, has a history of lambasting CEOs and pressuring them to take actions that would raise their companies’ share prices. Last week, his target was not a CEO but the world’s largest asset manager—BlackRock—which he called a “very dangerous company”.

Speaking at the CNBC’s Delivering Alpha Conference, Icahn warned particularly about the risks of high yield bond ETFs. He said these ETFs had bought many risky and illiquid bonds and it wasn’t clear who was going to buy them and at what price if investors head for exits in the event of a market sell-off. Icahn also painted an image of Fed chairwoman Yellen and BlackRock CEO Fink pushing a pile of high-yield bonds toward a cliff and said "they are going to hit a black rock."

Of late, bond ETFs have faced sharp criticism by many who fear that investors may face problems in executing their transactions if there is a sharp downturn. While there have been far reaching changes in the bond markets in recent years, some of the concerns about them have been overblown. (See: 13 Best and Most Interesting ETFs to Launch in 1H 2015)

Banks Exit Bond Markets; Funds Gain Assets

Due to enhanced regulatory capital requirements, banks have vastly curtailed their market making in bonds. Dealer inventory of bonds has declining rapidly while the bond market continues to grow. On the other hand, asset managers now play an increasingly important role in the bond market with over $317 billion in assets under management.

Considering the huge volume of assets under management, regulators are trying to determine whether they create systemic risk and should be designated as SIFIs. Such a designation would expose them to tough regulations including capital requirements and stress tests. (Read: 3 Sector ETFs to watch on revenue growth potential)

Is BlackRock a “Very Dangerous Company”?

BlackRock and other asset managers, unlike banks, invest only on behalf of their clients and do not invest on their account. Further asset managers do not receive any government support and do not provide any guarantee to their clients, whereas banks’ clients do have FDIC’s guarantee on deposits. While banks take client risk in many cases, in the case of asset managers risk remains with funds’ investors. So, BlackRock and other asset managers are not dangerous companies and do not pose any serious systemic risks, but considering the sums under their management, it would be prudent to ensure that these companies have robust risk management systems in place.

The Financial Stability Board has, for the time being, decided to focus on asset managers’ market activities rather than entire institutions. BlackRock has suggested many other measures to calm redemption fears, including increased credit lines with banks, holding more liquid assets and greater adoption of electronic trading platforms.

Will Rising Rates Spell Doom for Bonds?

As the Fed remains on track to raise rates in the coming months, many investors worry about the prospects for the bond market. While it is true that rising rates hurt bonds, don’t expect all bond investors to head for exits once the Fed starts rate hikes. Per BlackRock, 70% of their fixed income investors are pension funds and insurance companies. These companies try to match their long term liabilities with assets.

In fact, persistently low interest rates pose a serious threat to the solvency of these companies and higher rates are actually beneficial for them.  A rise in portfolio yields would improve the margins for life insurers. Higher yields also lower the present value of pension funds’ future liabilities and reduce the funding gap. (read: 2 ETFs in focus as the IPO market heats up)

Bonds are an important component of a well-diversified portfolio and so even though the 30 year bull market for bonds may finally end when the Fed starts raising rates, investors will still own some bonds in their portfolios. They may however need to focus on the right part of the curve. Foreign demand for US bonds, particularly Treasuries may actually increase when rates rise here, in view of the ultra-low rate environment in other parts of the developed world.

Do Bond ETFs Enhance Market Liquidity?

Investors’ quest for yield in the ultra-low interest rate environment has led to huge inflows into funds investing in risky asset classes such as high yield and emerging markets bonds. It remains to be seen how these ETFs holding rather illiquid asset will trade during a market sell-off.

BlackRock has a different theory regarding bond market liquidity. They contend that ETFs actually enhance bond market liquidity since buyers and sellers of ETFs trade among themselves and match trades without any actual creation or redemption of underlying assets.

ETFs--due to their transparent structure and ease of trading--have made it much easier for investors to buy and sell bonds even though the liquidity and trading of underlying assets has been declining. Despite their exponential growth, bond ETFs still account for a tiny fraction of the overall bond market and can not cause any significant disruptions in the bond market.

However, investors should always remember that ultimately the liquidity of an ETF is determined by the liquidity of its underlying assets. If there is an incremental liquidity in normal times, it is likely to disappear during times of severe stress.

Further liquidity does not only mean the ability to trade, it is also about the ability to trade at a fair price. During taper tantrum, many bond ETFs traded below the estimated value of their underlying bonds. Investors in illiquid securities like junk bonds, bank loans and emerging market debt, directly or via ETFs, should be well aware that liquidity would not always be available for these types of securities.

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