Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

An odd thing happened on the way to last year’s credit selloff: The market for risky debt broke into pieces, with some pieces becoming toxic and others remaining relatively in favor.

This is illustrated starkly by the two biggest high-yield exchange-traded funds, BlackRock’s $13.3 billion fund and State Street’s $9.2 billion ETF, which diverged in performance during the three months ended Dec. 31 by the most for a quarter since 2009.

The BlackRock junk-bond ETF lost 1.4 percent, while the State Street fund plunged 2.9 percent, almost twice as much. Assets in BlackRock’s fund during the period increased $1.7 billion, to $14.4 billion, while State Street's increased by $658 million, to $9.6 billion, data compiled by Bloomberg show.

Diverging Paths
Returns in the two biggest high-yield bond ETFs have increasingly diverged in recent months.
Source: Bloomberg

Some of those inflows to BlackRock came from big investment firms Franklin Resources and Hutchin Hill, which leaned heavily on the biggest junk-debt ETF as a place to park cash last year, even if just momentarily, as they sought to be nimble in a rocky market. Franklin, for example, added more than $200 million of the BlackRock fund’s shares to its holdings while Hutchin Hill purchased more than $100 million worth in the period ended Dec. 31, according to filings compiled by Bloomberg.

There are some fundamental reasons they may have been attracted to BlackRock’s fund, rather than State Street’s: It invests in slightly higher-rated junk assets and is bigger, leading to a greater average daily volume of trading. Those attributes gave it an advantage in the latter part of 2015, when investors were prizing flexibility and higher quality above almost all else.

In a statement, Franklin said it selectively uses "third-party ETFs in our allocation funds to provide efficient exposure to an asset class."

"ETFs may also be used in other funds on a short-term basis to deploy cash," according to the statement sent by spokeswoman Stacey Coleman.

It's not news that institutions are increasingly using credit ETFs as a more easily traded proxy for an underlying market of thousands of individual securities that trade rarely, if ever. But it's interesting to see how these big investors have been using them recently. It highlights how distorted the junk-debt market has become as investors prepare for redemptions and another leg down in the credit cycle.

No doubt there's been a historic decline in some bonds, especially the lowest-rated ones and those of energy companies. But investors haven't really abandoned the rest of the $1.3 trillion U.S. high-yield bond market just yet. Take a look at the gap in yields on the highest-rated and lowest-rated junk bonds: It has expanded to about the widest since 2009, with investors demanding more than 14 percentage points in extra yield to own the lowest-rated notes.

Split Signals
Investors have been piling into the highest-rated junk bonds while selling the lowest-rated ones.
Source: Bank of America Merrill Lynch index data

The divergence highlights the difficulty in using indexed funds right now. Some bonds have undoubtedly been thrown out with the bathwater, while others have unfairly remained afloat and are destined to decline substantially more. That injects a certain amount of unpredictability into the market.

It also highlights how much even the biggest investors rely on ETFs to maneuver in a market that's becoming more perilous, especially as they receive withdrawals or deal with other fast-moving cash. While the funds offer investors a tool in the short run, they may be helping to widen the gap between bonds that are in favor and those that aren't.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net