So far, 2012 has certainly been the year of the US-listed high yield bond ETF. After pulling in US$7 billion in new flows for the whole of 2011, the sector gathered almost the same amount in the first three months of this year alone, led by the iShares iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG) and State Street’s SPDR Barclays Capital High Yield Bond ETF (NYSE Arca: JNK).
The driving forces behind the flows are well understood. We are in an environment of very low yields, especially for government securities. Investors, particularly those looking to generate income, are challenged in finding investments that generate enough income for their needs. High yield has been a beneficiary of this environment, providing those investors who are comfortable with the credit risk they are taking on with a way to boost income.
All of these inflows into high yield ETFs have rightfully raised some questions about what impact the funds are having on the high yield market. In my opinion, some of the issues are not always broadly understood.
Trading Activity And Market Impact
Some investors look at the size of the flows into high yield ETFs and expect to observe pressure on both fund prices and the underlying bonds themselves. If everyone buys something then its price should go up, right? Despite their growth, ETFs are still a small part of the high yield market. As of a month ago there was US$29 billion invested in US high yield ETFs. That’s less than 3 percent of the US$1 trillion US high yield market.
The combined daily exchange-based trading volume of HYG and JNK is US$447 million, a significant increase over the volumes of just a few years ago, but still a small number when compared to the high yield bond market as a whole, which trades over US$5 billion a day. The total inflows of US$7 billion into high yield ETFs during the first quarter therefore represented less than two days of average trading in the underlying market.
So from a size and trading perspective, high yield ETFs represent just a small percentage of what is happening in the broader high yield universe.
Premiums And Discounts
High yield ETFs will at times trade at premiums or discounts to their underlying net asset values (NAVs). These premiums and discounts reflect investor demand for the ETFs. When buying interest is strong, premiums increase. When more investors are selling, premiums decline. During periods of high yield market stress high yield ETF premiums and discounts can have wider swings. This is a reflection of the illiquidity and volatility of the underlying high yield bond market. High yield ETFs are still ETFs. If there is an actionable difference in price between an ETF and its underlying holdings, then an arbitrage exists and investors will try to take advantage of it. That same mechanism is in place for high yield.
Simply put, in times of high market stress and volatility, a larger channel can open up between an ETF’s market price (at which the fund trades) and the NAV (which is determined by the ETF’s index pricing point). But this is no different than holding the bonds directly and observing a difference between the prices you value them at and the prices at which you would actually be able to buy and sell them.
But at pains of repeating the point, if the premium or discount to NAV is in some way actionable, in so far as one could trade the ETF against the underlying bond market and make a profit, then that would of course occur and the gap between price and NAV would close.
So why are high yield ETFs under such scrutiny? Let’s call it the curse of transparency. By, for the first time, shining a light on trading volumes, tradeable prices against valuation prices, intraday liquidity and changing fund sizes, ETFs provide the only real insight into the secondary market in an otherwise very opaque asset class.
My guidance is to enjoy the transparency and easy access that high yield ETFs afford you whilst being mindful that many other factors are driving the markets.
Alex Claringbull is managing director and fixed income portfolio manager for iShares ETFs, BlackRock. This blog is for information purposes only and should not be treated as a solicitation to buy or sell investment products.