Index fund managers are finding it hard to secure the bonds they need at the prices they want, forcing them to make trade-offs that can hurt investors and leave managers vulnerable in a market downturn.

Bond liquidity has all but dried up for corporate issues after new regulations and capital requirements forced Wall Street banks to slash their inventories of fixed-income products following the financial crisis. That's especially challenging for index fund managers who must acquire certain bonds -- or at least broad swaths of bonds -- to be able to track specific benchmarks.

The lack of liquidity also means funds may have trouble selling bonds in the event interest rates rise and the investors who have sunk about $1.2 trillion in net deposits into long-term bond funds since the end of 2004 head for the exits.

Bonds inventory at Wall Street banks has dropped to about $60 billion from about $250 billion since the 2008 credit crisis, according to the Federal Reserve Bank of New York, making them harder to trade, analysts and fund managers said.

"The days where you can go out and say, 'I want these ten bonds' ... and get the Street to offer them to you, are probably gone," said Josh Barrickman, head of bond indexing at Vanguard Group Inc, which oversees $325 billion in index bond fund and ETF assets. "So now it's more, 'what can I get and are those suitable substitutes for what I actually want?'"

To combat the problem, Vanguard has relied on more fixed-income trading specialists to hunt for hard-to-get bonds that are best suited for building efficient index portfolios, Barrickman said. Index funds have less latitude than actively managed funds, whose managers are paid to beat benchmarks, not track them.

More corporate and municipal index funds are sampling the bonds contained in their benchmark instead of trying to approach full replication of the index. They also are going outside their benchmark index to find substitutes for hard-to-get bonds, said Steve Sachs, head of capital markets at ETF provider ProShares.

Sometimes the sampling can be extreme, producing returns that severely lag their index.

The $30 million Market Vectors Pre-Funded Municipal ETF holds only about 60 bonds, tracking a benchmark with more than 46,000 issues.

It offers a unique slice of the bond market of pre-funded municipal bonds, but high transaction costs have produced a 12-month return net of fees and expenses of 0.92 percent in the year ending Sept. 19, which is 23 basis points, or 20 percent, lower than the broad benchmark’s return of 1.15 percent, according to Thomson Reuters data.

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