Markets

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

Credit investors have struggled for years to efficiently trade big chunks of riskier debt, but their short-term solution may be exacerbating their predicament.

Their approach to the efficiency issue has been to use big exchange-traded funds as a proxy for the actual debt. But problems are starting to emerge because it turns out it hasn't actually solved anything except these investors' short-term needs. In fact, they may have made the inflexibility of the $1.3 trillion U.S. junk-bond market even worse.

The more asset managers use these passively managed funds as a trading tool, the less they try to transact in the actual securities. This results in a downward spiral of less activity in the bonds, which pushes even more investors to use ETFs to make quick, broad-market bets. This is already taking a toll, according to a Barclays note on Feb. 17.

ETF Eclipse
Trading in the biggest junk-bond ETFs has ballooned in proportion to the overall market
Source: Barclays

"We estimate that this indirect effect reduced high-yield bond turnover by 20 percent in 2016," according to Barclays analysts Jeffrey Meli and Eric Gross. This phenomenon "could account for a substantial portion of the decline in turnover since the crisis," they noted.

Big Disparity
High-yield bond ETFs account for a disproportionate amount of trading relative to their assets
Source: Barclays Research, MarketAxess, Bloomberg

At the same time, it's clear that there's pent-up trading demand. Activity has increased drastically among high-yield ETF shares, which trade like stocks. The four biggest such funds had an average $1.6 billion of trading in its shares each day, even though the ETFs manage only a combined $37 billion of assets, the Barclays analysts noted. That compares with a $12 billion daily trading volume in the entire U.S. junk-bond market.

Trade Uptick
The biggest high-yield bond ETF, which trades as HYG, has seen a marked uptick in trading
Source: Bloomberg
Data tracks daily volumes in BlackRock's iShares iBoxx High Yield Corporate Bond ETF

This isn't a new problem. High-yield bonds have always traded relatively infrequently off exchanges. But many participants contend it became worse after the 2008 financial crisis, when big banks retreated from using their own money to facilitate trades. And it's been more prominent in people's minds because of the rapid growth in this market in the years after the crisis.

While this might seem to be just an annoyance for the most sophisticated traders, it does have broader significance. 

The reliance on ETFs has created a sense of liquidity that could be challenged during a severe market move that forces investors to actually deal with big chunks of actual bonds again. This has been a long-running concern, but this debt still hasn't been truly tested, nor have the problems been solved. In a worst-case scenario, traders would have a rough time determining true values for specific bonds, leading to severe losses for forced sellers.

While an increasing number of electronic-trading systems are available to help facilitate bond trades, none of them have successfully solved the problem of helping asset managers move large chunks of risky debt in one shot without altering market prices disproportionately.

ETFs have been a great tool for many investors. But the fix is reaching the natural end of its efficacy in terms of how much more it can address the true problem. If there's a sharp market reversal, the underlying market and all its issues could slap investors back to a harsh reality. 

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