Need for Speed Means ETF Trading Outpaces Bonds: Credit Markets
Trading in exchange-traded funds that buy junk bonds is increasing at a faster pace than transactions in the underlying debt as buyers seek a faster way to take advantage of a market returning 15.5 percent this year.
Volumes in the three-biggest junk ETFs increased to a daily average of $587.83 million this year, equal to 11.5 percent of daily trading in the bonds, data compiled by Bloomberg show. That’s up 90 percent from 2011, when the amount changing hands was equivalent to 7.3 percent of trading in the notes.
Speculative-grade bond ETFs are attracting record amounts of cash this year as Federal Reserve efforts to stimulate the economy by holding interest rates at almost zero since 2008 push investors into riskier assets. Bond buyers from retirees to the biggest banks are increasingly using shares of high-yield bond ETFs for fast access to debt with an annualized return of 21.8 percent since 2008, even as the risk of losses tied to rising interest rates is the greatest since 2007.
“Rising volumes are inevitable with an outperforming asset class,” said Neal Epstein, a senior credit officer at Moody’s Investors Service. “From an investment perspective, active management is de-emphasized when the ease of the exposure and the performance of the bonds has been so outstanding.”
The five-biggest junk ETFs have increased their holdings to $30.8 billion since the first such fund began in 2007 as the biggest banks reduced their corporate-bond inventories 77 percent to $53.8 billion. While the market for dollar- denominated high-yield debt has grown 10 percent since 2010, average daily trading volumes for the notes haven’t kept pace, increasing just 0.2 percent during the period, according to Bloomberg and Bank of America Merrill Lynch index data.
The ETFs, which seek to replicate returns on benchmark indexes, trade on exchanges like stocks and typically allow individuals to speculate on securities without directly owning them. Institutional investors are turning to them as a more efficient way in and out of a market that traditionally trades in private, over-the-counter transactions and where buying a broad cross-section of bonds has become more difficult, said Matt Tucker of BlackRock Inc. (BLK), which runs the largest junk ETF.
With the gap between real-time ETF pricing and less- frequent trading in corporate bonds, the “largely unproven” funds are at “medium risk” in a “market-stress event,” Fitch Ratings analysts wrote in a Dec. 19 report.
Elsewhere in credit markets, Dish Network Corp. sold $1.5 billion of 10-year bonds. Consolidated Precision Products Corp. is said to have set the final terms on $600 million of loans it’s seeking to finance its acquisition of Esco Corp. (ESCO)’s Turbine Technologies Group. Tobacco bonds issued by U.S. states gained after Philip Morris USA and other cigarette makers said they would distribute to 17 states $4 billion in payments previously withheld from a 1998 settlement.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, rose from a three-month low, climbing 0.8 basis point to a mid-price of 89.8 basis points, according to prices compiled by Bloomberg.
The Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 0.5 basis point to 110.5 at 10:11 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan advanced one basis point to 108.
The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, rose 0.4 basis point to 12.2 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Bonds of New York-based Citigroup Inc. were the most actively traded dollar-denominated corporate securities by dealers yesterday, with 151 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Dish, the second-largest U.S. satellite-television provider, sold its 5 percent notes due in March 2023 to yield 319 basis points more than similar-maturity Treasuries, Bloomberg data show. The deal was marketed earlier yesterday at $1 billion.
Proceeds will be used for general corporate purposes that may include spectrum deals, the Englewood, Colorado-based company said yesterday in a regulatory filing.
Consolidated Precision will pay interest on a $415 million, seven-year, first-lien term loan at 4.75 percentage points more than the London interbank offered rate, according to a person with knowledge of the transaction. A $185 million, 7 1/2-year second-lien term piece will pay interest at 9.25 percentage points more than Libor, said the person said, who asked not to be identified because the information is private.
The average yield investors demanded to buy a California tobacco bond fell 0.2 percentage point yesterday, Bloomberg data show. A tax-exempt Golden State Tobacco Securitization Corp. bond rated B3 by Moody’s Investors Service, six steps below investment grade, and due in 15 years, traded with an average yield of 5.34 percent. That’s 3.2 percentage points above a benchmark index, down from 3.56 percentage points Nov. 30.
Philip Morris, Lorillard Inc. and Reynolds American Inc. said Dec. 18 they would release the funds in exchange for credit against future payments toward the settlement. In the 14-year- old agreement, the producers make annual payments to 46 jurisdictions based on cigarette shipments to cover the companies’ liability in health-care cost litigation. The makers and the states were in disagreement over claims that market- share erosion should reduce the companies’ payments.
In emerging markets, relative yields narrowed to the least in almost two years, declining 2 basis points to 263 basis points, or 2.63 percentage points, according to JPMorgan Chase & Co.’s EMBI Global index. The measure, which has averaged 345.4 basis points this year, is the lowest since Jan. 5, 2011.
The average volume of high-yield bonds traded daily this year is $5.12 billion, equal to about 0.47 percent of the dollar-denominated notes outstanding, according to Bloomberg and Bank of America Merrill Lynch index data. That compares with an average volume of $5.11 billion in 2010, equivalent to about 0.52 percent of the market.
Trading in the three-biggest ETFs, run by BlackRock, State Street Corp. (JNK) and Invesco Ltd. (PHB), has increased more than four times from a daily average of $135.94 million in 2010, Bloomberg data show. Junk ETFs have attracted $8 billion of deposits this year, 25 percent of the inflows into mutual funds that buy the bonds, according to JPMorgan.
“Investors are looking for more efficient ways to trade the market and trade risk,” said Tucker, head of BlackRock’s iShares Fixed Income Strategy team. “It’s more challenging today to find multiple dealers who can offer me a security. As an investor, it can be harder for me to get trades done and build diversification.”
Activity in ETFs is accelerating as new risk-curbing regulations spur the biggest banks to cut the amount of their own money committed to facilitate debt trading. The 21 primary dealers that do business with the Fed have reduced bond inventories from a peak of $235 billion in October 2007 after the 27-country Basel Committee on Banking Supervision raised minimum capital requirements in 2010.
“It’s a reflection of the deteriorating liquidity in our market and the fact that the exchange-traded product, at least for the purposes of trading it every day, is certainly perceived as more liquid,” said Eric Gross, a credit strategist at Barclays Plc (BARC) in New York. If ETFs are compelled to buy or sell bonds to create or redeem shares, “their liquidity is bounded by our liquidity,” he said.
Investors have funneled $31.9 billion into junk-bond mutual funds this year, according to data compiled by JPMorgan, as the Fed’s plan to buy bonds and hold benchmark interest rates at 0 to 0.25 percent pushes them toward less-creditworthy borrowers.
The unprecedented inflows helped push speculative-grade debt prices to 104.46 cents on the dollar on Dec. 13, 0.51 cent less than the peak in January 2004, Bank of America Merrill Lynch index data show. Modified duration, a measure of the securities’ price sensitivity to yield changes, climbed to as high as 4.94 years on Nov. 30, the most since November 2007.
“We think risk/reward is not overly attractive for high- yield credit, and as such, recommend fairly defensive positioning heading into 2013,” Morgan Stanley credit strategists Adam Richmond and Jason Ng wrote in a Dec. 4 report. “Even if growth surprises to the upside, we cannot envision much more than a ‘coupon-clipping’ year.”
Rising interest rates pose a “medium risk” to corporate- bond ETFs, Fitch analysts wrote in a Dec. 19 report titled, “The ‘Bond Bubble’: Risks and Mitigants.” Investment managers with similar potential challenges are U.S. life insurance companies, which hold $2.1 trillion of corporate bonds, and hedge funds, which may experience magnified losses because of their use of leverage, or borrowed money, the analysts wrote.
Investors are increasingly using ETFs to express bearish bets on junk bonds as well as more optimistic views. Trading may occur without affecting the underlying bond market as long as prices remain stable and funds don’t have to create or redeem shares as a result of the activity.
“It’s indicative of a liquidity differential rather than a view differential,” Barclays’s Gross said. While the ETFs may provide some liquidity for the junk-bond market as it grows bigger, they are passive investors and unable to buffer price swings the way the biggest dealers traditionally did with their balance sheets, he said.
“They’re typically going to want to buy when everyone else wants to buy, and they’re going to want to sell when everyone else sells,” Gross said.
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