ETFs and Junk Bonds Are an Explosive Mix: Lisa Abramowicz

Computer programs seem to be having all the fun in debt markets these days. Human investors, on the other hand, are left scratching their heads, trying to figure out what just hit them.

Even in the $1.3 trillion U.S. junk-bond market, automatic, rapid-fire traders may be showing up more. That may seem odd, because this debt is bought and sold away from exchanges, often via phone calls and emails, making it difficult to trade by computer. But the advent of exchange-traded funds has made that much easier.

So on a day like Wednesday, when nothing in particular happened to make credit traders go wild, they still seemed to get pretty hyped up, at least based on frenetic trading in the most active high-yield bonds.

Junk-debt ETFs, which own a lot of this active debt, also saw a surge in trading.

And yet if you talk to a random sampling of investors, who make actual, human decisions, nothing in particular happened to cause the flurry of activity. Yes, there’s a good chance that the Federal Reserve will keep interest rates near zero for a longer period of time, but what is another couple of months after almost seven years of unprecedented monetary policy?

The key to what’s really going on here may very well lie in automated-trading programs that a growing number of hedge funds and institutions are using, or at least that’s how Christopher Ware, a portfolio manager at Vertical Ascent Partners, sees it. In other words, this debt market’s being driven by unemotional computers with preconceived notions of how markets operate.

Junk-debt ETFs have grown substantially since the first one was created in 2007 and now own more than $30 billion of assets, data compiled by Bloomberg show. They’re increasingly used by hedge funds and institutions, who want to quickly enter and exit this over-the-counter market, without spending hours or days trying to find someone to take the other side of their trade. And some of these funds rely on computer programming that takes its cues more from historical data than real-time reasoning.

This leads to some strange market activity, especially during times when there isn’t a clear direction to markets. And Ware sees more chaos to come as a result of this.

The implications of this computer-generated activity are vast, and go beyond just being an interesting technical blip. The big swings in flows and volumes is causing some traders to pull back entirely as they are unable to trust prices or trading as being real or rational. And while high-yield bond prices have risen quite a bit so far this month, some real companies, such as machine-parts maker NN Inc. have been struggling to raise money, which ultimately was supposed to be the purpose of this market.

For investors who want to avoid the unpredictable activity, it may be good to hold bonds that aren’t included in these ETFs. Or else they need to have a strong enough stomach to ignore the noise until something massive happens to give markets definitive direction.