Junk Bond ETFs: An Insider's View (HYG, JNK)
As an asset class, high-yield (or junk) bonds have never been as liquid as U.S. Treasuries or high-grade corporates. However, that track record has had little impact on ETFs such as the iShares iBoxx $ High Yield Corporate Bond Fund (NYSE: HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK). The two largest junk bond ETFs have seen volumes surge even as turnover in the funds' holdings slide, according to a recent Bloomberg piece.
The uptick in junk bond ETF volume comes amid recent controversy that includes a $725 million redemption in the SPDR Barclays Capital High Yield Bond ETF in May, where the seller allegedly took delivery of the actual bonds.
Despite the new found scrutiny and a market environment that would appear to not favor high-yield bonds, funds such as HYG and JNK have demonstrated their allure to investors. Some say these funds are even changing the high-yield game.
"They (HYG and JNK) are changing the nature of high yield – they are making it easier for people to trade in and out of high yield as an asset class," said Peter Tchir founder of TF Market Advisors in an interview with Benzinga. "Daily volumes in the ETF's are increasing and detracting from individual bond trading – something dealers don't like. Many investors had to invest in mutual funds with higher fees and restrictions before this, so mutual fund managers don't like it either."
Something else dealers and mutual fund managers may not be fond of is the respective sizes of HYG and JNK. HYG is home to $14.2 billion in assets under management while JNK's AUM total is north of $10.4 billion, according to data on the iShares and SPDRs Web sites. These statistics underscore the notion that investors are favoring ETFs over individual high-yield bonds.
"If you can buy or sell $25 million of the ETF with a cost of 10 cents, why would you buy 25 individual bonds, probably paying at least half a point, if not closer to 1 point," Tchir said. "Bonds are unique in that the price of $1 million high-yield bonds is quoted better than the price of $10,000. I can't think of another asset class that provides tighter bid/offer spreads for larger size trades. A move to smaller lot size in individual bonds and electronic trading is a likely outcome in my opinion. Those who laughed at 100 share trades in ETF's are realizing how quickly those volumes can grow."
New regulations introduced by Congress and the Basel Committee on Banking Supervision may also be impacting the high-yield bond market. Banks are being forced to pare their holdings of corporate bonds, creating confusion and possibly a trading arena that more closely resembles stocks.
"U.S. banks will hold very little in inventory," Tchir noted. "The Fed Stress tests also penalized high-yield bonds. It is causing some confusion, but in my opinion will lead to some central limit order system, i.e., an exchange, which will focus on small but frequent trades, around which things like dark pools will develop. It will look a lot more like equity trading in the future."
There are issues that regulators could focus on to the benefit of investors, in Tchir's opinion.
"I would like to see regulators focus on making sure yield to call or yield to maturity is done accurately and highlighted, because investors seem to focus on the dividend yield, but in reality, expected return should be based on yield to call rather than dividend yield as the pull to par effect is real for an ETF holder," he said.
Even amid the increased scrutiny and an unfavorable regulatory backdrop, junk bond ETFs continue to proliferate in number. At least six new funds with junk bond allocations have debuted this year. Some funds now offer investors exposure to international high-yield debt.
The prospect of global and emerging market junk bonds has proven popular with investors. The iShares Global ex USD High Yield Corporate Bond Fund (BATS: HYXU), a fund more tilted toward developed markets, has raked in $23.5 million in AUM in less than three months of trading. In two months on the market, the Market Vectors Emerging Markets High Yield Bond ETF (NYSE: HYEM) and the iShares Emerging Markets High Yield Bond Fund (BATS: EMHY) have attracted $9.8 million and $14.9 million in AUM, respectively.
The growth of international issues, as a percentage of the global high-yield market, has been impressive. International issues have surged to 35 percent last year from 10.9 percent in 1997, according Bank of America Merrill Lynch. While the growth of high-yield global bonds as a percentage of the overall market cannot be ignored, it is clear that if U.S. junk issues warrant liquidity concerns, foreign junk issues do as well.
"In all cases, it is key to remember that if bonds trade at 1% bid/offers, you can have a large move in the ETF whenever market sentiment changes," Tchir said. "So if the market is ‘bid without' the ETF will trade to the offer side or above (a premium) to where bonds are quoted. That makes some sense as it is hard to buy bonds, let alone a diversified portfolio.
"When sentiment changes and the market goes ‘offered only' then bonds will have bids drop, but the ETFs will apparently do even worse, as they will move from trading at or above offer to at or below bid. A bond might be 99/100 in a good market, then bad news hits whole market and it goes to 97.5/98.5."
Investors have also shown a willingness to embrace short-dated junk bonds, a fact highlighted by the success of the SPDR Barclays Capital Short Term High Yield Bond ETF (NYSE: SJNK). SJNK debuted in March and already has almost $112 million in assets under management. Even with SJNK's stellar start, this ETF should be viewed with caution, as it deals with other new high-yield debt funds.
Calling it the "eat like a parrot, poop like an elephant" phenomena, Tchir said the rush to short dated funds is frightening. "The amount to be made from short dated is relatively small, and if a company deteriorates, the short end is bidless and will trade far worse than I think many retail investors understand," he said.
For more on junk bond ETFs, click here.
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