Crowded ETF Exit Proving Costly as Bonds Trail: Credit Markets
Investors who sought exchange-traded funds as a faster way to trade corporate bonds are finding that they can be as expensive to trade as the underlying debt.
As trading in the three-biggest credit ETFs surged to unprecedented levels last month amid the market’s biggest losses since 2008, the funds’ shares dropped as much as 1.1 percentage points more than the net value of the less-traded securities they hold. The two largest high-yield bond ETFs have lost about 6 percent since reaching a five-year high May 8. That’s about 2 percentage points more than the loss for the Bank of America Merrill Lynch U.S. High Yield Index.
The gap reflects the extra charge investors paid for a speedier exit in a declining market by using ETFs that trade like stocks rather than buying and selling the less-liquid debt. Investors yanked about $1.83 billion of shares from the two-biggest junk ETFs last month, forcing sales of their holdings at a time when demand was evaporating.
“Just buying ETFs doesn’t solve the liquidity problem,” said Andrew Feltus, a money manager who helps oversee about $37 billion in U.S. fixed-income assets at Pioneer Investment Management Inc. in Boston. “You’re almost outsourcing your liquidity, because now your creator is the guy who’s going to have to go out and source the bonds in order to get it to work.”
Corporate bonds have lost 3.1 percent this year as investors prepare for the Federal Reserve to end an unprecedented bond-buying program that fueled average annual gains of 13.5 percent from the end of 2008 through 2012. The selloff accelerated after Fed Chairman Ben S. Bernanke said June 19 the Fed may start dialing down its $85 billion monthly debt purchasing program this year if growth is in line with the central bank’s estimates.
Shares of BlackRock Inc.’s $13.7 billion iShares iBoxx $ High Yield Corporate Bond ETF, the biggest of its kind, plummeted 4.3 percent in the six days ended June 24, while the net value of its assets dropped 3 percent, data compiled by Bloomberg show. The fund’s share price fell to the lowest level in 12 months on June 24, to $89.04. The lowest value last month for the underlying assets was $89.66, the data show.
“The price reflects where you can exchange risk,” said Matt Tucker, head of iShares fixed-income strategy at BlackRock, the biggest ETF provider. “It’s the correct price. The reality is the majority of the high-yield market doesn’t trade every day.”
High-yield, high-risk bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
Investors are clamoring for an easier way to slip in and out of a $5.3 trillion U.S. corporate-bond market that’s mostly traded over the counter, especially as the biggest banks reduce the amount of money they use to facilitate trading. Primary dealers that trade with the Fed cut their holdings of the notes by 76 percent from the peak in October 2007 through the end of March in the face of new risk-curbing rules.
While the face value of dollar-denominated junk bonds outstanding has almost doubled since 2006, trading volumes have increased just 14 percent in the period, according to data from a Bank of America Merrill Lynch index and Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
“People are using ETFs to trade risk when investors need to access the markets and adjust positions, and need to do so in a quick market,” Tucker said in a telephone interview. “They’re being more widely used by more investors as a liquidity tool in stressed markets.”
As debt prices slumped last month, investors disproportionately turned to the funds, with shares that trade like stocks, to reduce exposure to a cross-section of bonds that trade over-the-counter. They’re finding that “while bond ETFs claim to offer instantaneous liquidity, this is not the case when liquidity in the underlying securities dries up,” JPMorgan Chase & Co. (JPM) analysts led by Nikolaos Panigirtzoglou wrote in a July 5 report.
The average daily trading volume in BlackRock’s junk-bond ETF during the past 30 days soared 71 percent above the six-month average, compared with a 3 percent decline for the broader high-yield bond market in the same period, Bloomberg and Trace data (NTMBHV) show. Volumes in State Street Corp. (STT)’s SPDR Barclays High Yield Bond ETF, which trades under the ticker JNK, jumped 62 percent. The BlackRock fund trades with the ticker HYG.
With fixed-income ETFs, “you get something that is trying to track, as closely as possible, prices of assets which are not necessarily easy to buy or sell,” said Jason Brady, a fund manager who helps oversee about $86 billion at Thornburg Investment Management Inc. in Santa Fe, New Mexico. “That dynamic is a challenge.”
In June, investors pulled about $1.1 billion from State Street’s junk-bond ETF and $760.7 million from the BlackRock fund after Bernanke told Congress on May 22 that the U.S. central bank may start reducing its bond purchases. Bernanke told reporters June 19 that policy makers may end the Fed’s stimulus, which has funneled more than $2.5 trillion into the financial system since 2008, by mid-2014 if the economy meets expectations.
Since May 21, yields on corporate bonds in the U.S. have risen 85 basis points, with the most-frequently traded securities leading the selloff.
In June, relative yields on high-yield bonds owned by ETFs widened 8 basis points more than other debt from the same issuers, according to data from Bank of America Corp. (BAC) strategists Oleg Melentyev and Neha Khoda. That difference has more than doubled since the end of May, showing “the extent to which ETF bonds underperformed just by virtue of being in a high-yield ETF portfolio,” the strategists wrote in a note dated July 1.
“Premiums and discounts can be much larger in times of particularly significant buying or selling pressure, like what we have experienced in the last few weeks,” BlackRock’s Tucker said in an e-mailed statement. “In these cases, buyers and sellers of ETFs adjust the value they place on the underlying securities, and the ETFs’ prices simply reflect the market’s collective and ongoing value of the underlying assets at any point in time.”
BlackRock (BLK)’s $19.2 billion investment-grade bond fund, which trades under the ticker LQD, has lost 7.3 percent since the end of April, compared with a 5.9 percent decline on the Bank of America Merrill Lynch U.S. Corporate Index.
State Street’s $9.1 billion junk-bond ETF has lost 5.2 percent since the end of April compared with a 3.2 percent decline on the Bank of America Merrill Lynch U.S. High Yield index.
BlackRock’s speculative-grade debt fund has fallen 4.8 percent in the period, with its shares plummeting $1.25 on May 31 compared with a 17-cent decline in net asset value, Bloomberg data show.
“I don’t think the ETF is giving you anything that the underlyings can’t give you,” said Mark MacQueen, co-founder of Sage Advisory Services, which oversees $10.5 billion, with $2 billion in ETF strategies. “It’s an easier, quicker way to do it.”
Elsewhere in credit markets, the extra yield investors demand to hold investment-grade corporate bonds globally rather than government debentures rose for a sixth week, reaching the highest level in more than eight months. Sales fell to the slowest pace this year, while the cost of protecting corporate bonds from default in the U.S. and Europe declined for a second week.
Relative yields on investment-grade company bonds from the U.S. to Europe and Asia widened 3 basis points to 159 basis points, or 1.59 percentage points, according to the Bank of America Merrill Lynch Global Corporate Index. Spreads climbed to 161 on July 1, the highest since Oct. 12. Yields rose to 3.1625 percent from 3.0759 percent on June 28.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, declined 0.5 basis point last week to 86.6 basis points, according to prices compiled by Bloomberg. The gauge has fallen from 97.6 on June 24, the highest since December.
Both indexes typically decline 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 swap protecting $10 million of debt.
Bonds of New York-based Goldman Sachs Group Inc. (GS) were the most actively traded dollar-denominated corporate securities by dealers last week, accounting for 3.3 percent of the volume of dealer trades of $1 million or more, Trace data show.
A two-part, 2 billion euro ($2.57 billion) offering from Oracle Corp. led $27.7 billion of corporate-bond sales worldwide last week, a 16.7 percent drop from the prior week and the least since $22.3 billion in the period ended Dec. 28, Bloomberg data show.
Oracle’s offering was split between 1.25 billion euros of 2.25 percent notes due January 2021 paying 68 basis points more than the mid-swap rate and 750 million euros of 3.125 percent, 12-year securities at 98 basis points, Bloomberg data show.
The S&P/LSTA U.S. Leveraged Loan 100 Index rose for the first time in eight weeks, rising 0.29 cent from a five-month low to 97.42 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has returned 2.02 percent this year.
In emerging markets, relative yields narrowed 17.4 basis points to 336 basis points, the second straight weekly decline, according to JPMorgan’s EMBI Global index. The measure has narrowed from 395.3 on June 24, the highest since June 2012.
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