An interesting story. As these funds grow larger and larger their impact on the market will continue to grow. They will create some problems and some opportunities, but they cannot be ignored. It reminds me a lot of when the CDS indices first got traction. Many chose to ignore them as being irrelevant to cash or too complex, but now everyone pays attention to them. Whether you like or hate the CDS Indices they are important and the flows they generate and the arbs they create impact the market. These ETF’s aren’t quite that important yet, but are getting there.
Exchange-Traded Junk Funds Roil Bond Market as Retirees Jump In
2012-01-13 05:00:35.0 GMT
By Shannon D. Harrington and Lisa Abramowicz
Jan. 13 (Bloomberg) — Funds that give everyone from
retirees to institutional money managers easier access to junk
bonds are fueling the biggest price swings in more than two
years after their buying power surged 10-fold.
Exchange-traded funds that track high-yield bond indexes
exceed $22 billion, up from about $2 billion three years ago.
While that’s just 2 percent of the $1 trillion in U.S. corporate
speculative-grade debt outstanding, ETFs are among the biggest
holders of benchmark securities, including those of Las Vegas-
based casino owner Caesars Entertainment Corp. and HCA Inc.
ETFs, which drew Congressional scrutiny last year as more
complex and riskier versions emerged, are adding to volatility
because of rules that promote trading. A measure of price swings
for junk bonds was seven times higher in November than May,
making it harder for the neediest borrowers to raise capital.
Their influence in the market for high-yield, high-risk debt is
becoming similar to what ETFs, which have grown to $1.5 trillion
from $109 billion in 10 years, have done in other assets.
“These large concentrations of holdings have a dramatic
impact on individual issues,” said Jason Rosiak, the head of
portfolio management at Pacific Asset Management, the Newport
Beach, California-based affiliate of Pacific Life Insurance Co.
which oversees $2.9 billion. “When the market is up the offers
on these issues will be higher and conversely when the market is
lower, or there are expected outflows, bids dry up quickly or
are lower on the names held in the ETFs.”
While cash has poured into ETFs, they haven’t outperformed.
New York-based BlackRock Inc.’s $11.6 billion iShares iBoxx High
Yield Corporate Bond Fund, which started in April 2007, has
returned a cumulative 28.2 percent since inception, with
dividends reinvested. A $9.26 billion in assets ETF from State
Street Corp. in Boston has returned 25.6 percent since December
2007, the month after it was created.
Speculative-grade bonds on average returned 40 percent
since April 2007, compared with 36.3 percent for investment-
grade debt and 37.3 percent for U.S. Treasuries, according to
Bank of America Merrill Lynch index data.
ETFs allow individual investors to speculate on debt ranked
below investment grade — less than Baa3 at Moody’s Investors
Service and BBB- at Standard & Poor’s, without owning the bonds.
Unlike mutual funds, whose shares are priced once daily, ETFs
are listed on exchanges and are bought and sold like stocks.
The average default rate the past five years for
speculative-grade bonds was 4.67 percent, compared with 0.2
percent for investment-grade debt, according to Moody’s.
With the Federal Reserve saying it will keep benchmark
interest rates near zero through at least mid-2013, ETFs are
gaining in popularity with individuals. The average rate for a
new one-year certificate of deposit offered by major banks
dropped to 0.76 percent on Jan. 4, down from 2.5 percent in
2010, according to Bankrate.com. Junk bonds yielded 8.3 percent
as of yesterday, Bank of America Merrill Lynch index data show.
Newport Beach, California-based Pacific Investment
Management Co., owner of the world’s biggest bond mutual fund,
started an ETF in June that buys junk bonds tracking a Bank of
America Merrill Lynch index.
As ETFs focusing on bonds grow, so have prices swings in
fixed-income securities. A measure of volatility over 30-day
periods for the Finra’s Active High Yield U.S. Corporate Bond
Index rose to as high as 11.1 in November, from 1.5 in May.
The BlackRock and State Street ETF’s own a combined 7
percent of Caesars’ $3.3 billion of 10 percent notes due in
2018, making them the biggest holders among money managers that
disclose positions, according to data compiled by Bloomberg.
As Europe’s debt crisis erupted last year, causing a sell-
off in assets worldwide and an 11 percent drop in the BlackRock
fund’s share price, the Caesars bond plunged to as low as 54
cents on the dollar on Oct. 4 from about 90 cents at the end of
July, Trace data show. It jumped to 70.6 cents by yesterday as
the ETF climbed to $89.12 a share from $81.05 on Oct. 4.
The BlackRock and State Street ETFs own 7.3 percent of
hospital operator HCA’s $3 billion of 6.5 percent bonds due in
February 2020, Bloomberg data show. Those bonds have traded from
as low as 93.75 cents on the dollar on Aug. 8 to a high of 105.6
cents on Oct. 28, Trace data show. Six times since the bonds
were sold in July, they have swung in price by at least 6 cents
within about a one-month period.
“Uncertainty breeds volatility,” said Kevin Quigg, the
global head of strategy and consulting at State Street’s ETF
group. “The volatility that’s being expressed in the
marketplace is much more reflective of what’s going on in the
Such price swings aren’t being created by ETFs, only made
transparent, said Matt Tucker, the head of iShares Fixed Income
Strategy at BlackRock.
The fund “has made the high-yield market visible for the
first time for investors,” Tucker said. “They hadn’t realized
that the high-yield market was that volatile. It was always that
volatile; it just wasn’t that easy to see.”
Quigg said bonds bought by ETFs are screened to ensure that
the securities can be easily traded without prices being pushed
around by the funds. “There’s a safeguard against the
investment vehicle affecting the broader market,” he said.
Average daily trading in the two largest high-yield ETFs
more than tripled to $304.4 million last year from $95.5 million
in 2009, even as the volume of junk bonds exchanging hands
shrunk 16 percent to $2.83 billion, according to data compiled
by Bloomberg and Trace, the bond-price reporting system of the
Financial Industry Regulatory Authority, or Finra.
ETFs are different from mutual funds in that their managers
don’t actively buy and sell bonds themselves. Instead, dealers
purchase and dispose of securities on their behalf based on
demand for shares in the funds. The bonds that are then
exchanged for shares in the ETF largely mirror the indexes that
the ETFs seek to track.
Traders from hedge funds to bond dealers are increasingly
tracking the daily activity of ETFs, with some looking for ways
to profit by speculating on which bonds will be sold or bought.
Others seek to make money on abnormally wide gaps between where
ETF shares trade and the market prices of the bonds they own.
“There’s a growing number of groups that are out there
doing the ETF arbitrage,” said Peter Tchir, founder of New
York-based hedge fund TF Market Advisors. “That’s a pretty good
development for the market. It will add to the volatility, but
it also encourages” trading by both buyers and sellers, he
The rise in ETF assets and related trading activity is
generating concern that bonds held by the funds are making them
more susceptible to wider price swings because junk-rated
securities are thinly traded compared with equities and have
relatively wide differences between bid and offer prices,
according to Rosiak.
“The market can recognize based on expectations of inflows
and outflows what names there will be demand for, or what names
there will be supply for,” Rosiak said in a telephone interview
Jan. 10. So, as near-term volatility rises, speculation
increases that money flowing out of or into ETFs will
accelerate, causing bonds held by the funds to “get hit or bid
up first,” he said.
As ETFs globally surpassed $1 trillion in assets in 2009,
regulators stepped up scrutiny.
The U.S. Securities & Exchange Commission has examined
whether ETFs that use derivatives to amplify returns contributed
to equity-market volatility in August and on May 6, 2010, when
the Dow Jones Industrial Average plunged almost 1,000 points in
an hour and bounced back just as quickly. The regulator said in
March 2010 it wouldn’t approve new ETFs that make substantial
use of derivatives.
ETFs that buy and sell commodities futures gained attention
because of the risks from contango, in which the cost of
contracts with longer expiration dates become more costly than
those with nearer-term expirations. That erodes a fund’s value
because fund managers have to sell commodities futures before
they expire and buy new ones to avoid taking delivery of the raw
materials they’re tied to.
Investors in exchange-traded products backed by gold own
2,357.3 metric tons of the metal, more than the amount held by
all except four central banks, Bloomberg data show.
During a Senate Banking subcommittee hearing on the funds
in October, Senator Jack Reed, a Democrat from Rhode Island and
chairman of the subcommittee, questioned whether critics were
correct in calling them the “new weapons of mass destruction.”
BlackRock, which manages $1.2 trillion of fixed-income
assets and is the biggest provider of ETFs, has urged lawmakers
to bar funds that rely on derivatives from being marketed as
ETFs. The firm doesn’t use derivatives in its junk-bond ETF.
During an investor call in October, BlackRock Chief
Executive Officer Laurence D. Fink said the industry risked
following the downfall of the mortgage-bond market, where once-
simple products that companies such as his pioneered evolved
into complex variations with risks investors didn’t understand.
“That was a failure of the mortgage market,” Fink said
during the Oct. 19 conference call with investors. “We need to
be very assertive as a firm and outspoken that we will not
allow, at BlackRock, the lack of disclosure on these products.”
Even if high-yield bond ETFs are driving volatility, the
added transparency and greater trading activity will benefit the
market, said Tchir.
“One of the things that always used to be true of high-
yield was it would show very low volatility, but it didn’t
really trade so it was kind of a fake low volatility,” he said.
“The market would just shut down.”
Now funds are exploring trades such as buying or selling
the ETF shares while taking the opposite bet on the underlying
bonds, earning a profit when the two converge. Such dislocations
emerged last month as the price of BlackRock’s iShares ETF
shares soared to as high as 2.6 percent more than the fund’s net
asset value on Dec. 27. The premium shrunk to 0.9 percent on
A similar trend developed after indexes of credit-default
swaps were created last decade, allowing traders to arbitrage
the gaps between the indexes and the underlying bonds or
contracts on individual companies in the benchmarks.
The swaps indexes “created this whole new class of
traders,” Tchir said. “It kept the price fair.”
Performance of the funds hasn’t kept up with the market,
trailing their benchmarks since their inceptions. BlackRock’s
ETF has underperformed its index each of the past three years,
trailing by as much as 3.8 percentage points as the market
recovered in 2009 from the collapse of Lehman Brothers Holdings
Inc., according to the fund’s website.
State Street’s SPDR high-yield ETF has returned an annual
6.07 percent since inception, compared to 9.2 percent in its
benchmark, the Barclays Capital High Yield Very Liquid Index.
“It’s very hard for an ETF to beat the index, and even the
average manager, considering how much forced trading an ETF has
to do in a relatively illiquid market,” said Gershon
Distenfeld, who oversees high-yield credit investments at
AllianceBernstein LP in New York.
For Related News and Information:
Credit markets columns: TOP CM <GO>
People news: WNEWS <GO>
Top financial company news: FTOP <GO>
–With assistance by Christopher Condon in Boston. Editors:
Philip Revzin, Robert Burgess
To contact the reporters on this story:
Shannon D. Harrington in New York at +1-212-617-8558 or
Lisa Abramowicz in New York at +1-212-617-3503 or
To contact the editor responsible for this story:
Alan Goldstein at +1-212-617-6186 or