The first quarter saw very strong retail investment flows into high-yield debt securities and the rapid growth of ETFs as bond investment vehicles appears to be a major driver of the market’s growth.

The first quarter saw very strong inflows into high-yield bond ETFs. According to Fitch, this should improve liquidity and broaden the high-yield investor base, though increased volatility may follow.

Fitch, one of the major credit rating agencies, believes high-yield bond ETFs are improving liquidity and should broaden the high-yield investor base. However, they say that the trend may also contribute to market volatility and potentially de-link some aspects of bond pricing from credit fundamentals.

Retail investors hungry for yield in a low interest rate environment directed significantly more cash into high-yield bonds during the first quarter. Fitch estimates that total retail fund flows into high-yield bonds reached $15 billion in the quarter ended 31 March. Of that total, Fitch reckons 20% or more probably resulted from new flows into bond ETFs.

US-listed ETFs such as BlackRock’s iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SSgA’s SPDR Barclays Capital High Yield Bond ETF (JNK), which are designed to track major high-yield indices, continued to capture a large share of new flows, but the number of bond ETFs is growing quickly.

In Europe, London-listed funds such as the iShares Markit iBoxx $ High Yield Capped Bond ETF (SHYU), the PIMCO Short-Term High Yield Corporate Bond Index Source ETF (STHY), and the SPDR Barclays Capital Euro High Yield Bond ETF (JNKE) have all attracted significant inflows. STHY from Pimco and Source is the newest of these three and has already accumulated assets of over $88 million since its launch just under one month ago.

Fitch calculates that expanded use of high-yield ETFs as a short-term trading platform will likely fuel more market volatility, particularly in periods of macro stress, when risk re-allocation could drive big swings in ETF flows. In periods of asset inflows such as the first quarter, this should support tighter spreads on new issues, particularly for large leveraged issuers whose bonds must be acquired by ETFs.

At the same time, forced selling could be exacerbated by hot money flows during periods when fundamentals are weakening and investors are pulling back from riskier asset classes. This has the potential to reinforce liquidity-driven price moves in high-yield bonds that may have little or no relation to changes in credit fundamentals.