Pensions love their junk, but ETFs could surprise

Redemptions could drive selling in underlying bonds.

September 4, 2013

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anxiety roller coaster stressLow returns in U.S. bond markets are enough to make the term junk bond look a lot less scary, particularly in the pension world where plan sponsors are increasingly turning to high-yield debt to generate much-needed returns. Earlier this month, for example, the US$14.7-billion Teachers’ Retirement System of Louisiana hired AllianceBernstein to invest $325 million global high-yield debt. The move will help the pension fund garner higher returns in what will be its first foray into overseas speculative-grade bonds. Speaking to Bloomberg, Dana Brown, the system’s director of public markets, said, “If rates are extremely low in the U.S., and there is some disconnect in credit opportunities in Europe and places in Asia, now is the time to branch out to see what is available. We’re broadening our diversification.”

Louisiana might have been looking to the Kentucky Teachers’ Retirement System, which recently posted a solid 14.1% fiscal year return, with its high-yield bond portfolio returning 8.8%.

So junk bonds might be a good anodyne for plan sponsors dealing with the pain of rising rates, right? Well, a new report released by credit rating agency Fitch warns of some new factors in the high-yield bond market that could add more of what plan sponsors don’t want—volatility.

Fitch’s report warns that the expanding market for high-yield bond-based exchange-traded funds (ETFs) could have a negative impact on the bonds they follow. Why? Because ETFs are playing a growing role in the U.S. fixed income market, particularly when it comes to corporate high yield. Noted Fitch, average daily trading volumes (on a weekly basis) for the five largest high-yield corporate bond ETFs more than tripled to more than $1.5 billion in early June from about $470 million in early May.

Investors are turning to fixed income ETFs to quickly enter and exit their fixed income positions as they deal with the spectre of rising rates. However, according to Fitch, a quick exit doesn’t come without a cost—especially in the high-yield space where big ETF redemptions will inevitably drive selling in the underlying bonds. “For context, Federal Reserve Bank of New York research indicates that an investor or dealer liquidation of more than $250 million in corporate bonds in one day could begin to adversely affect corporate bond prices,” said the rating agency.

It’s not exactly news, and it’s been covered before. But it’s worth bearing in mind as investors, especially plan sponsors, become more comfortable investing in the high-yield space. As they become more at ease with junk bonds, plan sponsors also need to keep a close eye on how new factors, such as growing demand for ETFs, could add some volatility along the road.

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