Buyers of junk bonds are retreating to the market’s more obscure securities as the rise of exchange-traded funds fuels concern that such fast-moving cash is exacerbating price swings.
Investors are delving into smaller, older junk-bond issues that trade less frequently, pushing yields on such securities to the lowest on record, while those on more frequently traded notes are holding above lows reached last May, Barclays Plc data show. Wells Fargo & Co. credit strategists are recommending a list of bonds not owned by ETFs that investors should consider buying to lessen price volatility when everyone from retirees to hedge funds pull cash from them.
The divergence illustrates the force that ETFs have become in the market for high-yield, high-risk debt after amassing more than $35 billion of the securities since BlackRock Inc. started the first vehicle focused on the debt seven years ago. In order to offer investors in-and-out, stock-like access to bonds, the ETFs seek the newest, most liquid debentures as they maneuver in a market typically transacted over the phone.
“You don’t want to be selling when they’re selling, you don’t want to load up on their liquid bonds,” said Marc Gross, a New York-based money manager at RS Investments. “Sometimes you don’t want the market volatility.”
As dealers commit less of their own money to facilitate corporate-bond trading, ETFs are exerting more control over transaction volume that hasn’t kept pace with the market’s growth. Primary dealers that do business with the Federal Reserve cut their corporate-debt holdings by 76 percent since the peak in 2007 through last March in response to risk-curbing regulations.
At the same time, ETFs are blossoming as investors race to riskier assets in less-traded markets as the central bank keeps interest rates near zero for a sixth year. Assets in the 10-biggest junk ETFs have swelled 24 percent since May 2012, according to data compiled by Bloomberg.
“The ETFs allow me to go into markets that are harder to get into,” Bill Larkin, a fixed-income money manager who helps oversee about $500 million at Cabot Money Management Inc., said in a telephone interview from Salem, Massachusetts. “I’m trying to manage risk using ETFs.”
The funds tend to have more influence on trading when sales of new corporate bonds slow, such as last month, forcing investors into the secondary market, according to George Bory, head of credit strategy at Wells Fargo. More than 75 percent of the 200 most-actively traded bonds in February were included among the funds’ holdings, particularly BlackRock’s ETF that trades under the ticker HYG, Wells Fargo research shows.
Prices on that fund’s biggest holding, Sprint Corp.’s $4.25 billion of 7.875 percent notes due in 2023, have swung by as much as 4.2 cents this year, compared with a 1.95-cent fluctuation in a Bank of America Merrill Lynch index that tracks U.S. bonds with BB ratings.
The fund’s third-biggest holding, First Data Corp.’s $3 billion of 12.625 percent notes maturing in 2021 and rated Caa1 by Moody’s Investors Service, have moved in a range of 4.55 cents, Bloomberg data show.
ETF-owned bonds “are often first movers when the high-yield market pulls back or rallies,” Wells Fargo analysts wrote in a Feb. 28 report.
The number of fixed-income ETFs has grown, with firms from Pacific Investment Management Co. to Guggenheim Investments starting funds to invest in junk bonds. The second-biggest high-yield bond ETF is State Street Corp.’s $10.2 billion SPDR Barclays High Yield Bond fund that trades under the ticker JNK.
The funds don’t exacerbate volatility, said Stephen Laipply, a BlackRock product strategist who focuses on fixed-income ETFs. They only illuminate price swings inherent in more-frequently traded securities, he said.
ETFs sell shares pegged to the value of a portfolio of assets. When they receive redemptions, they deliver securities to authorized dealers to sell into the market. When they receive deposits, they sell shares to the dealers in return for a basket of assets that usually try to mimic returns on a designated index.
While they’re marketed to individuals, a growing number of institutions are using ETFs as a way to slip in and out of broad cross-sections of debt that would take days or weeks to assemble by purchasing each individual security.
“Liquidity for corporate-bond investors cuts both ways; it can work to your advantage and it can hurt you,” Wells Fargo’s Bory said in a telephone interview. “If you’re happy with certain credits, you may want to move away from the more-liquid security into the less-liquid securities.”
In the year after the collapse of Lehman Brothers Holdings Inc. caused the biggest credit seizure since the Great Depression, investors demanded as much as 1.95 percentage points more to own harder-to-trade debt than more-frequently brokered notes, Barclays data show. That gap has shrunk to 0.31 percentage point, with the average yield on the older, smaller issuances falling to a record 5.56 percent on March 4, the data show.
Newer and easier-to-trade debt is yielding 5.25 percent, up from a record low 4.93 percent reached last May, according to the data. During that same period, the price of shares in BlackRock’s junk ETF have declined 2.25 percent to $94.12.
Buyers are looking for extra yield beyond the ETFs, which have seen trading volumes surge 800 percent since 2008, according to a Greenwich Associates study distributed on Feb. 27. In contrast, average daily volumes in the broader high-yield bond market have risen 69 percent, according to data from Bank of America Merrill Lynch indexes and Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Outstanding debt tracked by the speculative-grade index has grown 73 percent in the period to $1.26 trillion.
While trading in ETF shares doesn’t always result in sales or purchases in the underlying assets, investors increasingly track the flows when deciding when and what to buy.
“In terms of the ETFs, especially in the high-yield market, they’re a major cause of volatility,” said Thomas Chow, a Philadelphia-based money manager at Delaware Investments. “As the ETFs need to rebalance, there’ll certainly be a market reaction to those activities.”
More than half of U.S.-based investors surveyed by Greenwich Associates this year said they rely on fixed-income ETFs mostly because they provide easier, quicker access to relatively illiquid markets.
“Our bigger concern is what happens when expectations change,” said Mirko Mikelic, a senior money manager at ClearArc Capital Inc., who helps oversee $7 billion of assets. “When rates rise you’re going to see people exiting ETFs and you’re going to see the Street not trading as much. What happens when everyone tries to exit the theater at once?”
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