Corporate Bond ETFs Volume Swell a Good Sign

High-yield, speculative-grade corporate bond exchange traded funds have gotten a lot of flak over perceived liquidity issues, especially if investors experience periods of extreme market stress. However, junk bond ETFs have proven to be sufficiently liquid as more investors eschew the primary markets for the ETF investment vehicle instead.

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"ETFs that track iBoxx indices have seen unprecedented liquidity over the last month, highlighting their growing popularity among market participants," according to financial information services company Markit.

For instance, the widely observed iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG) and iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE:LQD) both track Markit iBoxx indices.

Specifically, iBoxx backed ETFs experienced a record $27.6 billion of exchange traded volume in June, and the assets under management of iBoxx-benchmarked ETFs now stand at a record $107 billion.

HYG shows an average 12.3 million shares traded per day while LQD has an average volume of 3.6 million shares, according to Morningstar data.

As many ETF observers have noted, volume begets volume. These ETFs that track notoriously illiquid markets have been growing in popularity as investors sought out liquid instruments to express their views on the fixed-income market. While trading volumes in the fund have increased, trading in the underlying debt market has not been particularly elevated, reflecting the increased usage of ETFs as a more liquid proxy for exposure.

The heightened volatility in daily flows suggests that the increased activity is a result of rising usage among bond dealers. Banks may be utilizing bond ETFs like HYG as an alternative to their own stockpiles of riskier debt securities, relying on an ETF as an easy source of bonds for client redemptions. If a client gives money to a dealer to buy certain amount of high-yield debt, the broker could use the money to acquire a junk bond ETF that can be redeemed in kind for underlying debt securities, which is then given back to clients.

ETFs offer a convenient solution for dealers with clients redeeming debt securities. Unlike mutual funds, which sell securities for cash in cases of client redemptions, ETFs allow investors to exchange shares for baskets of underlying securities.

While we have witnessed robust volume and activity in these bond ETFs, some naysayers were worried that investors would rush out the last second to sell bonds in response to rising interest rates, which would make it costlier for high-yield bond ETFs to meet redemptions in a notoriously illiquid speculative-grade market.

Additionally, Wall Street banks, which would have been able to soften the blow and buy these bonds, may no longer be able to stand to provide additional liquidity after new regulations and capital requirements imposed following the financial crisis forced banks cut inventories.

Naysayers feared that selling pressure in the ETF may not be perfectly reflected by the illiquid underlying market, potentially widening the tracking errors between the ETF’s price and net asset value.

However, the secondary market for junk bond ETFs has bolstered available liquidity and acted as efficient pricing instruments for issues held by ETFs. For instance, HYG and LQD saw a total of $23 billion of turnover over June.

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