The world’s largest junk bond exchange-traded fund had one hell of a day last week, after the closure of a Third Avenue bond mutual fund sparked a wider sell-off in the credit market.
If Friday was a test, then the fixed income ETF experiment appears to be working, although the stakes keep getting raised. The experiment involves taking a prehistoric, over-the-counter market like bonds and trying to bring them into the modern world with a lightning-speed, equity-trading vehicle like an ETF. Some think this is a permanent evolution that we all should praise while others see a Jurassic Park-esque disaster waiting to happen.
Regardless of which side you fall on, the numbers behind Friday’s trading of the iShares iBoxx High Yield Corporate Bond ETF, better known as HYG, are fascinating.
Here's what caught our eye.
HYG traded three times more than any corporate bond ETF in history
HYG posted trading volume of $4.3 billion on Friday, which was its most ever by a country mile as seen in the chart below. Not to mention more than three times the amount any other corporate bond ETF has ever traded. And this volume wasn’t a few big fish but rather thousands of smaller trades as only a handful of trades were over $10 million.
To help put $4.3 billion into perspective, that made HYG the fifth most traded equity on Friday—sandwiched between heavyweight blue chip stocks Apple and Amazon as seen in the table below. (As an aside, seven out of the ten most traded securities were ETFs as well. The crazier the day, the more ETFs you tend to see in the Top 10.)
As a whole, junk bond ETFs traded about $6 billion worth of shares while actual junk bonds traded about $11 billion. In other words, ETFs made up approximately one-third of the $17 billion worth of the day's high-yield debt trading. This is about the same percentage that equity ETFs typically make up of all equity trading. It shows that these newer fixed income ETFs are being leaned on more and more relative to their underlying markets, just as with equity ETFs.
More people traded HYG options than Apple stock
Despite HYG’s record smashing volume, options on the HYG traded even more. About 800 million shares of HYG options exchanged hands on Friday. That is $6.5 billion worth, which is more than Apple’s stock traded. It’s also 10 times more than any other day for the nearly-decade old ETF as seen in the chart below.
This spike in options volume is a sign of heightened volatility and positioning before this week’s Fed decision. It also is another growing source of liquidity that HYG benefit’s from. If you add in options activity, you could say there was more trading via junk bond ETFs than there was in actual junk bonds—a fact that could either be seen as a victory by ETF providers or further fan concerns that the ETF market has outstripped the realities of the underlying debt.
More than 80 percent of HYG’s volume was away from the underlying bonds
HYG saw outflows of $560 million on Friday, its third worst day ever. But this was only 13 percent of its total $4.3 billion in trading volume, meaning 87 percent of the trading didn’t involve touching the underlying bonds. To put it another way, 87 percent of the trading was between two parties over an exchange and/or through a market-maker taking the other side. Some 13 percent, however, involved the redemption of HYG shares to the ETF's provider, Blackrock, in exchange for a basket of junk bonds. If you throw in options activity, it’s more like 95 percent. This is a stat that is already being promoted by the issuers to show that the junk bond ETFs are bringing liquidity to the market. And they have a good point, it does. However, that still doesn’t change the fact that there is still a liquidity mismatch. Friday's session saw a lot of natural buyers in the market which helped everything along.
HYG barely registered a discount to NAV
HYG closed the day with a price just 0.7 percent below its net asset value, or NAV. In the history of the ETF that discount wouldn’t even make the top 50 worst despite the historic 2 percent drop in its total share price. The lack of a discount is really a result of the bonds Blackrock uses in the creation and redemption baskets combined with the increase in market participants. Plus, HYG has only 8 percent of CCC-rated, or really junky junk bonds, as opposed to the now infamous Third Avenue Focused Credit Fund, which the majority of its holdings in CCC-rated and even unrated bonds. This is a subtle but important distinction.
So while only 22 percent of the bonds in HYG's holdings traded on Friday, 100 percent of the bonds in HYG’s creation and redemption baskets traded. This means there was easier and faster arbitrage for the "authorized participants" that support ETFs. This is why even calling it a “discount” may not even be the right term. It really should be called the “arbitrage band.” As such, HYG’s arbitrage band has—as seen in the chart below—narrowed significantly over the years, to the point where 2013's 'taper tantrum' and last Friday are barely noticeable.
There is a 71 percent difference between HYG’s price and total return
Despite hitting its lowest price level since 2009, HYG is still up 50 percent since its inception in 2007. This shows how valuable income (better known as the 'search for yield') is to investors in junk bond ETFs. The chart below shows that the price return of HYG is -21 percent since inception, but if you throw in income it jumps to 50 percent. Conversely, the chart also suggests that HYG could have a lot more room to fall.
But if Friday was a test, it looks like the losses investors suffer will only be from the value of the junk bonds HYG holds and not from the structure of the ETF itself. Time will still tell if the doomsday scenario will materialize for bond ETFs, but so far the experiment is showing positive results.
Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News.