Newsflash for Bond ETF Buyers: Junk Traders Don’t Work for Free

The ETF Launches to Watch in 2015

There usually isn’t free lunch in markets.

This may be a painful lesson learned by the hordes who’ve funneled into debt mutual funds and exchange-traded funds since the 2008 financial crisis to get cheap, quick access to less-traded, higher-yielding securities.

It’s easy to buy shares in the funds, which trade daily on exchanges. Investors can do it online, with a click of a mouse.

Here’s the problem: The hours, or potentially days spent by actual bond traders trying to negotiate and find buyers and sellers are not free. Those people expect to get paid to either take on risk, or find someone else to do it -- and we’re not talking minimum wage.

Right now, it’s usually easy to find someone willing to buy risky debt, thanks to rampant stimulus around the world. Dollar-denominated corporate bonds of all ratings have gained an annual average of 7.3 percent since the end of 2009, according to Bank of America Merrill Lynch index data.

Some day, that will presumably change -- and someone will have to pay. The likely candidates are the end investors in these funds, according to Alberto Gallo, head of European macro-credit research at Royal Bank of Scotland Group Plc.

“Asset managers are still giving a ‘free liquidity option’ to investors,” Gallo wrote in a note Thursday. “Investors will have to eventually pay for this either upfront, or in terms of higher volatility.”

Trading Slump

The gap between how easy it is to trade mutual-fund shares and how hard it is to buy and sell assets such as high-yield bonds and leveraged loans is widening.

In 2015 alone, a year in which the Federal Reserve says it’s still planning to raise interest rates, investors have poured $46 billion into mutual funds and exchange-traded funds focused on corporate bonds, according to data compiled by Wells Fargo & Co.

They now own about 22 percent of outstanding high-yield bonds, up from about 12 percent in 2006, data compiled by JPMorgan Chase & Co. show.

While the size of the U.S. bond market has swelled 23 percent since the end of 2007 through the end of last year, trading has fallen 28 percent in the period, according to data compiled by the Securities Industry & Financial Markets Association. JPMorgan chief Jamie Dimon said in a letter Wednesday to shareholders that new regulations have made it harder to trade across bond markets.

The mismatch in liquidity between mutual funds and their underlying investments has raised concerns at the International Monetary Fund, where analysts released a report this week saying the dynamic could pose a risk to financial stability.

Not only do such funds account for a growing proportion of less-liquid debt markets, but their investors tend to either pour cash in or yank it out at the same time.

While Gallo argues it’s unclear how exactly this will threaten to destabilize markets, he’s sure that someone is going to bear the cost of this divergence in liquidity when the market turns. Most likely, it’ll be the individual investor.

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