A new study from investment research house Morningstar, has found that high yield bond exchange-traded funds play a significant role in relieving market stress during volatile periods. The report was produced to challenge claims that ETFs may actually play a damaging role in the functioning of bond markets.
Jose Garcia-Zarate, Senior ETF Analyst for Morningstar’s European Passive Fund Research.
Morningstar’s report – “High-Yield Bond ETFs – A Primer on Liquidity” – analysed net ETF creation or redemption data (primary market activity), as well as on-exchange traded volume data (secondary market activity) between January 2008 and mid-May 2016 for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK), the two most popular high yield ETFs listed in the US.
“In conducting this research, our aim is to demonstrate whether certain concerns expressed about high-yield bond ETFs can be justified,” said Jose Garcia-Zarate, Senior ETF Analyst for Morningstar’s European Passive Fund Research. “The visibility of heavily traded high-yield bond ETFs has made them an easy target for criticism, often cited as a factor in market volatility and hard to exit in times of market stress.
The study found that ETF trading was significantly more frequent in the secondary market compared to the primary market: the median secondary/primary market ratio for the iShares iBoxx $ High Yield Corporate Bond ETF ranged between 5 and 8. This indicates that between 5 and 8 US dollars were traded between holders of existing ETF shares in the secondary market before the ETF manager had to purchase or sell a single US dollar worth of high-yield bonds in the primary market to meet creations or redemptions from the fund. During the same period, the median ratio for SPDR Barclays High Yield Bond ETF ranged between 3 and 5.
It also revealed that in times of market stress in the underlying high-yield bond market, secondary/primary market ratios for the ETFs spiked considerably above their median range values. This indicated that heavy trading of ETFs in these periods had been largely netted off between holders of existing ETF shares, without unduly impacting the liquidity of the underlying high-yield bond market.
For an analysis of high-yield bond ETFs domiciled in Europe, Morningstar assumed a 30/70 trading ratio for the on-exchange/over-the-counter (OTC) secondary market. The analysis focused on the three largest high-yield bond ETFs: the iShares iBoxx Euro High Yield Corporate Bond ETF (IHYG), the iShares iBoxx $ High Yield Corporate Bond (SHYU), and the Pimco Short-Term High Yield Corporate Bond Source ETF (STHY). The median secondary/primary market ratio for each fund thus far in 2016 has ranged between 4 and 12.
“Our analysis suggests that far from being agents of instability, high-yield bond ETFs have acted as a safety valve, allowing investors to express their investment views without unduly affecting the underlying market,” added Garcia-Zarate. “The bulk of secondary trading is regularly netted off between buyers and sellers of existing ETF shares.
“High-yield bonds are clearly not free of risk. However, we feel it is important not to cloud what would be a welcome debate about the fundamentals driving investors to an asset class formerly known as “junk bonds” with ill-informed judgments about ETFs as the chosen vehicle for investment.”
Morningstar concludes its study by commenting on the scenario of a severe liquidity crunch in the underlying high-yield bond market. The firm writes that this would affect any investor in the asset class, irrespective of vehicle. If creations and redemptions are halted due to no liquidity in the underlying market, the ETF would by definition have evolved into a closed-end fund. That being said, as long as both buyers and sellers remain in the secondary market, holders of ETF shares are still afforded an escape route despite the primary market coming to a standstill.
The conclusions reached by such research papers continue to illuminate how the liquidity benefits inherent in a well-functioning secondary market, such as enhanced tradability and improved price discovery, has led to the increased popularity of high yield bond ETFs in recent years. From under $20bn in assets under management at the end of 2010, the global high yield ETF market has grown to $51bn in AUM as of the end of May 2016.