The bond investor used to be the stuffy alter ego to the shoot-from-the-hip stock trader. Bond buyers would painstakingly evaluate which companies would most likely pay back their debt, determine whether they were being sufficiently compensated for any risk of default and then sit back and enjoy regular interest checks and eventual repayment.
Many bonds traded infrequently, if at all, but that made little difference to the buy-and-hold debt investor. Other investors, however, in search of more attractive returns, wanted in on the bond market, but not the time-consuming process of corporate analysis or uncertainty of pricing in an opaque market. If only there was a way to trade quickly.
Enter the exchange-traded fund, whose shares trade like stocks, even if they own a basket of bonds. Investors used them as a way to trade in the bond market without all the muss and fuss.
ETFs have provided clear benefits to the $8 trillion U.S. credit market, but as the events of the last few days have demonstrated, they can be a double-edged sword. The same factors that make equities more volatile than debt in general, such as high-frequency trading strategies or pack-mentality mood swings, apply to bonds when traded in a similar format.
Over the past week, ETFs proved valuable as a way for traders to quickly pivot in response to changing sentiment. BlackRock’s ETF experienced $9.8 billion of volume just in its shares last week, with an unprecedented $4.3 billion of volume on Friday alone, three times more than any corporate bond ETF in history.
Trading in the junk-bond market was above the year’s average last week, with an average $9.1 billion of volume each day, but below the $9.3 billion traded in the week ended on Feb. 6, according to Finra’s Trace data. None of the days was a record for activity in the broader $1.3 trillion market, the Trace data show.
These ETFs worked exactly as they should, giving traders a way to place their bets in an uncertain time during which trading in the underlying market has lagged behind its growth. While they did experience hundreds of millions of dollars of redemptions, the vast majority of activity remained in the ETF shares, away from the underlying market.
But the ETFs also demonstrated their drawbacks as magnifiers of the market’s sharp mood swings and distorted barometers of sentiment. Fear feeds on itself. After Third Avenue’s $788 million mutual fund opted to liquidate and gate in the remaining investors, market participants had a collective anxiety attack. Which fund would be next? What’s the next shoe to drop? Will everyone suddenly start pulling their money out? Is this the beginning of the end for riskier credit?
Suddenly, everyone seemed at risk. And as a result, anyone who traded in the credit ETFs was also at risk. ETF shares plunged the most in a two-day period since 2011, even though nothing much had changed fundamentally in the market. In fact, the only thing that changed was that high-yield bonds got cheaper, probably making them a better buy and offering investors longer-term value.
In the past, such a move indicated that the market would most likely fall further. But just days later, investors appear to be returning to junk-debt markets. ETF shares were rebounding as of 11:01 a.m. in New York on Tuesday, gaining the most in about a year, according to data compiled by Bloomberg.
The noise created by ETFs has consequences, just perhaps not as severe and immediate as some, such as Carl Icahn, have suggested. It may fuel panic, and the longer investors panic, the longer they have reason to panic. Longer-term investors can’t completely ignore trading in the funds, but they have to recognize that they are not entirely a reliable gauge of disaster, or prosperity for that matter. Sometimes a storm is just a squall.
Trading in ETF’s generate a lot of noise, and sound and fury can indeed signify nothing, or very little. In the past week, investors would probably have benefited from trying to ignore, or even moving in the opposite direction of the crowd. They would be well served to avoid reacting too hastily to sudden mood swings.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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