Sourcing Liquidity in Rising Rate Strategies

Chief Investment Officer, Fixed Income and Model Portfolios

This post is relevant to institutional investors interested in trading exchange-traded funds (ETFs) in significant volume. Individual investors do not always have access to liquidity providers to trade ETFs as referenced below. As we have highlighted over the last several months, investors can take a variety of approaches to help reduce interest rate risk in their portfolios. In our view, one of the most intuitive ways is to simply hedge the interest rate risk of existing exposures in a bond portfolio. In the same way that exchange-traded fund (ETF) investors have embraced currency-hedged equity strategies, we believe strategies that hedge the interest rate risk of popular fixed income strategies could see similar levels of adoption when rates start to rise. The premise is similar—both approaches enable investors to preserve exposure, yet hedge the risks they don’t wish to take. However, hedging of any kind often sparks questions of mechanics and then liquidity and capacity from investors. It is important to remember that currency forwards and U.S. Treasury futures contracts are among the most liquid financial instruments in the world. As we will explain below, the mechanics of trading interest-rate-hedged strategies are generally no different from executing any other fixed income ETF strategy. One of the key differentiating factors of our approaches to rising rate strategies is based on how they are constructed: Maintain traditional bond exposure but dial down the interest rate risk through hedging. As a result, each of the strategies is constructed in the same way as a long-only bond stategy. However, a second step occurs whereby the strategy seeks to offset the interest rate risk of the bond portfolio by selling U.S. Treasury futures contracts. Given that Treasury futures are among the most liquidly traded futures contracts in the world,1 the additional cost of executing these trades is generally de minimis in most market scenarios. As a result, even though these strategies do not trade as much average trading volume as some other traditional bond ETFs, the underlying liquidity available is usually the same, if not greater, than the underlying securities themselves. Let’s look at a real-life example of a $35 million trade that was executed seamlessly in the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD). Essentially, the strategy is long a broad portfolio of U.S. fixed income and short Treasury futures to offset the interest rate risk exposure across the yield curve. This trade happened in two tranches on September 4, 2014. At that time, AGZD was trading, on average, 6,036 shares a day, or about $300,000.2 The customer contacted the WisdomTree capital markets desk to get a better understanding of the underlying liquidity of the strategy in addition to the onscreen ETF volume. The capital markets team explained that the liquidity available in the marketplace would be the lesser of the long bond portfolio volume and the short Treasury futures that the Fund holds as hedges. In this case, the market value of the outstanding bonds in the Barclays U.S. Aggregate Index is $17.4 trillion.3 Given that most fixed income securities trade over the counter, there is generally less transparency about average daily trading volume in fixed income as compared to equities. However, the Federal Reserve recently reported that U.S. Treasury securities trade, on average, $489 billion a day.4 Given that this represents only 36% of the portfolio, we believe that aggregate bond strategies are among the most liquid in the market.5 For the short portion of the portfolio, U.S. Treasury futures trade $240 billion average daily volume.6 This means that ETF market makers have at least $240 billion of daily liquidity to translate into the AGZD ETF for any customer. ETF market makers can then hedge themselves by replicating the underlying basket of the ETF. In the case of AGZD, if a market maker sold the ETF to a customer, they are short the ETF, and would then look to buy its equivalent positions of the underlying basket. In this case, the market maker would buy bonds in the Barclays U.S. Aggregate Index and sell a combination of U.S. Treasury futures. Given the differences in daily traded volume, it is the hedge that determines the available liquidity. Let’s look at how the trade in AGZD worked for this particular customer. As we mentioned, two tranches needed to be done for administrative reasons. The first one was traded at 10:37:12 on September 4, 2014, and the print can be seen below. The highlighted box shows that 397,502 shares (about $20 million worth) traded at $50.06. The offer on screen at the time was $50.10. So 65x the average daily volume of the ETF traded 4 cents inside the offer. We would interpret this as having no impact on the ETF price. Just to be sure, let’s look at the second print. That same day at 15:29:01, 298,215 shares (about $15 million worth) of AGZD printed at $50.10. Again, the highlighted yellow box shows the print by the arrow at $50.10, and the offer at the time was $50.10. Again, no price impact to the ETF. This is an illustration of the theory of liquidity that we explained. This customer wanted to hedge the interest rate risk in the portfolio with an ETF that didn’t have much regular daily volume. The customer did due diligence on the Fund and its underlying liquidity by using all the available resources, including the capital markets team at WisdomTree. What the customer discovered is that AGZD fit the investment needs and that $240 billion of liquidity was available in the marketplace. The customer then worked with the trading platform to use the services of a market maker to translate that $240 billion of underlying liquidity into the ETF at the requested size and time. The result was two trades done without price impact. Additionally, it is worth noting that liquidity is available on both entry and exit to the strategy. Market makers are often agnostic regarding buys or sells and just look to hedge themselves with underlying liquidity. Thus, when the customer intends to sell a position, regardless of AGZD’s daily onscreen volume, the volume of the underlying basket will again be available, just as it was on the above examples.         1Source: Chicago Mercantile Exchange (CME), as of 8/31/14. 2Source: Bloomberg, based on 30-day average volume, 9/4/14. 3Source: Barclays, as of 10/31/14. 4Sources: Federal Reserve, Bloomberg, as of 10/29/14. 5Source: Barclays, as of 10/31/14. 6Source: Chicago Mercantile Exchange (CME), as of 8/31/14.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions of U.S. Treasuries, where losses may be exaggerated, potentially losing more money than the actual cost of the investment, and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

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About the Contributor
Chief Investment Officer, Fixed Income and Model Portfolios

Rick Harper serves as the Chief Investment Officer, Fixed Income and Model Portfolios at WisdomTree Asset Management, where he oversees the firm’s suite of fixed income and currency exchange-traded funds.  He is also a voting member of the WisdomTree Model Portfolio Investment Committee and takes a leading role in the management and oversight of the fixed income model allocations. He plays an active role in risk management and oversight within the firm.

Rick has over 29 years investment experience in strategy and portfolio management positions at prominent investment firms. Prior to joining WisdomTree in 2007, Rick held senior level strategist roles with RBC Dain Rauscher, Bank One Capital Markets, ETF Advisors, and Nuveen Investments. At ETF Advisors, he was the portfolio manager and developer of some of the first fixed income exchange-traded funds. His research has been featured in leading periodicals including the Journal of Portfolio Management and the Journal of Indexes. He graduated from Emory University and earned his MBA at Indiana University.