Think Twice Before Assailing Junk Bond ETF Liquidity

Fueled by talk of the Federal Reserve tapering its quantitative easing program, Treasury yields started rising in earnest in May.

That yield spike prompted in spreads between high-yield bonds and Treasuries to widen, usually a negative sign, and the result was a June swoon for junk bonds that led to intense scrutiny of high-yield bond ETFs.

The iShares iBoxx $ High Yield Corporate Bond ETF (NYSE:HYG) and the SPDR Barclays High Yield Bond ETF (NYSE:JNK) are the two largest U.S. junk bond ETFs with a combined $23.4 billion in assets under management. Those funds and others became whipping during the May-July stressed market for high-yield bonds as critics asserted these funds did not provide market participants with sufficient liquidity and made the tapering sell-off worse.

There is evidence to suggest that high-yield bond funds behaved as expected during the recent period of elevated market stress and ETF critics, as is par for the course, are once again off base. A new study from BlackRock's (NYSE:BLK) iShares unit, the world's largest ETF issuer, indicates that HYG actually increased liquidity and price discovery for market participants during the recent sell-off.

"As liquidity in the underlying bond market contracted, exchange liquidity increased dramatically for HYG; this allowed buyers and sellers of HY to meet and trade on exchange away from the over-the-counter (OTC) market. The secondary market for ETFs actually served to enhance available fixed income market liquidity, and it also provided a source of price discovery for the underlying bond market," according to the study.

HYG. JNK and rival funds have also been dinged for substantial outflows, but outflows from U.S. HY mutual funds of $19.5 billion were nearly four times the outflows from U.S. HY ETFs, which totaled $5 billion, according to the study by Matt Tucker and Stephen Laipply.

Year-to-date, investors have pulled cash from JNK and HYG, but some other junk bond ETFs have not seen comparable outflows. Additionally, HYG does not even rank among the top-10 ETFs in terms of 2013 outflows.

What is noteworthy is that increased liquidity to HYG during a period of increased market volatility did not require redemptions in the ETF's underlying holdings of which there are currently 836.

"During periods of increased market volatility, as was the case during the period we examined, OTC bond market liquidity generally declines as trading becomes concentrated in a subset of larger and more liquid issues, and investors have difficulty transacting in less liquid names," wrote Tucker and Laipply.

"Prices for securities that are not trading may not fully reflect new market information. As a result, many OTC quotes and therefore index values and net asset values (NAVs) may not be representative of actionable trader and investors may observe a larger variance between the share price of a fixed income ETF and its NAV. As a result of the arbitrage mechanics described above, we believe that the observed divergence is attributable to a significant extent to price discovery rather than to any true discrepancies in valuation between the secondary exchange on the OTC market.

Confirming the notion that HYG acted as expected when volatility surged is the fact that on May 29 when over $1 billion changed hands in the ETF in exchange volume, redemptions were just $180 million, or 6:1 ratio. HYG now has $14.5 billion in assets under management, down from the number seen at the start of the year, but total that is still strong enough to easily absorb $180 million in redemptions.

Since May-early July junk bond melee, there have been other examinations of high-yield ETFs, one by Citigroup, in which the bank concluded the ETFs are "structurally sound."

"Importantly, the great majority of this increased liquidity did not require the redemption of the ETF's underlying bonds in the OTC market. The ratio of exchange volume to actual redemptions for HYG was roughly 6:1. HYG also provided robust price discovery, as expected, and behaved very much in line with the framework outlined in the prior publication," noted Tucker and Laipply.

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