Are ETFs rattling the junk market?

Plunging high yield ETFs point to problems.

January 16, 2012

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junk in trunk(Source: Benefits Canada) Last Thursday saw a big shakeup in the junk market. The thing is, it didn’t come from the actual high yield debt market – it came from the ETFs that track it. ETFs that invest in high yield bonds plunged nearly 2% on Thursday even though the underlying market was pretty sleepy that day.

Both the SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) dropped 2%.

So what does this say about ETFs?

First and foremost, it adds more fuel to the fire regulators are lighting under the ETF industry. Regulators are worried enough about he potential of ETFs to negatively influence equity markets – now there’s room to blame them for rattling debt markets too. Indeed demand for junk ETFs has surged substantially in a relatively short period of time — ETFs tracking high yield bonds now exceed $22 billion, up from just $2 billion just three years ago.

Of course, that’s a drop in the ocean compared to the $1 trillion in US corporate speculative-grade debt market – but ETFs are now among the biggest holders of benchmark securities like Las Vegas giant Caesar’s Entertainment Corp. And that puts ETFs in a very powerful position according to comments made by Jason Rosiak, head of portfolio management at Pacific Asset Management in Newport Beach. Last week he told Bloomberg that price swings for junk bonds were seven times higher in November than May. ETFs are to blame he argues.

This large concentration of holdings by ETFs has had a dramatic impact on individual issues according to Rosiak – and it’s made it hard for some to raise capital. “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.”

If easier access to high yield bonds through ETFs is indeed rattling the market, it could have a knock-on effect for pension funds that are increasingly looking to junk bonds to enhance their credit strategies. As the ETF market expands into new asset classes and areas of focus, maybe it’s time for another layer of due diligence: the potential for ETF flows to impact pricing.

The question for plan sponsors is should pension funds start to examine the role ETFs play in moving the securities they hold? Is it a risk factor? And in the end, should it really matter if ETFs are bringing more capital and (arguably) more liquidity into some asset classes?

Depending on what regulators decide about the role (or non-role) ETFs play in market volatility, I think it’s definitely worth considering. The question is, what do you think? Feel free to share your comments below.

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