High-Yield ETFs Lure Investors Bypassing Dealers: Credit Markets
Exchange-traded funds that own junk bonds are attracting unprecedented sums of cash from institutional investors seeking to slip in and out of the market as dealer inventories decline.
Institutional holders own 51 percent of BlackRock Inc.’s high-yield ETF, up 11 percentage points this year, according to data compiled by Bloomberg. The portion at State Street Corp. (STT)’s fund has grown to 60 percent, a rise of 18 percentage points.
The two funds, which allow individual investors access to the junk-bond market for as little as $37.59 a share, are attracting buyers from Bank of America Corp. (BAC) to Northern Trust Corp. as primary dealers gut corporate bond holdings by 81 percent since 2007. The market shift was underscored last month, when an investor redeemed as much as $780 million shares in State Street’s fund for the equivalent amount of bonds.
“Liquidity is the main reason that we’re using high-yield ETFs right now rather than high-yield bonds,” Tim Anderson, chief fixed-income officer at RiverFront Investment Group LLC in Richmond, Virginia said in a telephone interview.
“In the good old days you could call up one of the major firms and there’d be a halfway decent shot you could sell $15 million, $30 million of bonds to them on the line,” said Anderson, whose firm is the sixth-biggest institutional shareholder in State Street’s fund. “They’re not keeping the same inventories anymore.”
Dealer holdings of corporate bonds that mature in more than a year have dropped to $44.8 billion from as high as $235 billion in October 2007, according to data from the Federal Reserve Bank of New York.
Bank of America and Morgan Stanley (MS) are among the five biggest shareholders of both BlackRock and State Street’s ETFs, accounting for $1.7 billion of the securities in both funds, Bloomberg data show. The banks are two of the 21 primary dealers that trade directly with the Fed.
“ETFs have increasingly become a more viable way to express credit views,” said Eric Gross, a credit strategist at Barclays Plc in New York. “We’ve seen corporate bond liquidity go down across both investment grade and high yield.”
Elsewhere in credit markets, Moody’s Investors Service said its Liquidity-Stress Index fell to an unprecedented 3.3 percent in May from 3.9 percent in April, the previous record low, the ratings company said today in a statement. The gauge measures the percentage of speculative-grade borrowers with the lowest liquidity rating.
High-yield, high-risk debt is rated below Baa3 by Moody’s and lower than BBB- at Standard & Poor’s.
The cost of protecting corporate bonds from default in the U.S. rose for a fourth day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 1.1 basis point to a mid-price of 127.1 basis points as of 11:23 a.m. in New York, according to prices compiled by Bloomberg.
The index typically rises as investor confidence deteriorates and falls as it improves. Credit-default 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 contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, rose 0.06 basis point to 37.5 basis points as of 11:24 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, with 31 trades of $1 million or more as of 11:24 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
ETFs typically allow individual investors to speculate on securities without directly owning them. Unlike mutual funds, whose shares are priced once daily, ETFs are listed on exchanges and are bought and sold like stocks.
The funds generally don’t buy securities directly when they receive inflows or sell them to meet outflow requests. Instead, an authorized participant receives cash from investors and uses it to buy securities in exchange for fund shares. With redemption requests, the approved participant returns shares to an ETF’s manager and receives securities.
An investor used State Street’s ETF to anonymously obtain almost $780 million of speculative-grade bonds on May 10 without moving prices in the secondary market.
The investor exchanged as much as 19.7 million shares in the fund for the equivalent of about $779.3 million in speculative-grade bonds held by the ETF, Bloomberg data show. The redemption, the biggest in the fund’s history, came after the investor accumulated shares over several weeks, according to Knight Capital Group Inc., which brokered the trade.
Debt holdings of BlackRock’s iShares iBoxx High Yield Corporate Bond Fund, whose ticker symbol is HYG, have soared to $14.2 billion since its inception in April 2007. State Street’s SPDR Barclays Capital High Yield Bond ETF (JNK), which trades as JNK, has amassed $10.5 billion since opening in November 2007.
Banks are reducing inventories as lawmakers worldwide set limits on risk-taking after the worst financial crisis since the Great Depression led to $2 trillion of losses and writedowns.
“As long as something like JNK or HYG is easy to trade and relatively liquid, I’m not sure why anyone would go through the hassle of chasing down all the bonds, unless they were very good at doing it,” said Chris Hempstead, director of ETF execution at WallachBeth Capital LLC in New York. “It may be an affordable way to get exposure to the bonds.”
ETFs have been “aggressively marketed” to individual investors on the Internet, according to Moody’s.
“The rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seems to be increasing investors’ risk,” Neal Epstein, a senior credit officer at Moody’s in New York, wrote in a May 28 report.
The State Street and BlackRock high-yield ETFs trailed benchmark indexes by 1.3 percentage points in May, Bloomberg data show. State Street’s lost 3.5 percent compared with a decline of 2.2 percent for the Barclays Capital High Yield Very Liquid Bond Index. BlackRock’s dropped 3.2 percent versus a 2 percent loss on the iBoxx Liquid High Yield Index.
“Even though ETFs were perceived as more liquid, we must remember that they ultimately have to go through our market,” Gross at Barclays said. “They’re only as liquid as the underlying” securities, he said.
While using high-yield ETFs can be “frustrating” when performance diverges from benchmark indexes, the funds offer a chance to buy bonds in sizes that investors might otherwise be unable to get, Anderson said. Also, he said, over a longer term, the tracking error tends to be less.
“We have a very high degree of certainty that the ETF trade will go through,” he said. “It enables us to take a little bit larger exposure than we would otherwise because the liquidity is better.”
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