Popular ETFs dedicated to high-yield bonds have faced a media backlash after a large investor reportedly used one of the funds to quietly acquire nearly $800 million worth of junk debt this month.
Ratings agency Moody’s this week said more institutional trading of ETFs may create risks for individual investors and is “credit negative” for ETF managers State Street (NYSE: STT), BlackRock (NYSE: BLK) and Invesco (NYSE: IVZ).
Earlier this month, an unidentified investor exchanged nearly 20 million shares of SPDR Barclays Capital High Yield Bond ETF (NYSEArca: JNK) for bonds held by the fund, according to reports. [Will More Big Investors Use ETFs to Disguise Trades?]
State Street, which manages JNK, has refuted criticism of high-yield ETFs.
Jim Ross, global head of ETFs at State Street, in a Financial Times article said he was “surprised” by the Moody’s warning.
“Exchange traded funds have, without doubt, been a positive factor for the high yield bond market. They have boosted overall liquidity and brought greater involvement by market makers, encouraging them to post prices on bonds that would otherwise have been more difficult to trade,” Ross told the FT. “Just as we have seen in the U.S. muni bond market, ETFs have helped to provide greater transparency and to strengthen price discovery in the high yield bond market.”
The large JNK trade has put the spotlight on the complex “in-kind” creation and redemption feature of ETFs. Institutions known as authorized participants can trade large blocks of ETF shares in exchange for the underlying securities. [The ETF Creation and Redemption Process Explained]
In the JNK trade, the investor established a large position in the junk bond ETF, then redeemed the shares in exchange for the underlying high-yield bonds, rather than cash.
Moody’s warning
Moody’s says it’s worried that large trades in ETFs could result in premiums and discounts to net asset value, which create additional risks for unsuspecting investors.
“As cheap alternatives to actively managed mutual funds, their use is being promoted in retirement plans. However, the rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seems to be increasing investors’ risk,” Moody’s said in a Barron’s report.
For example, Moody’s said the big JNK trade resulted in the ETF trading at a discount after it had traded at a premium for months.
Ross in the Financial Times story said this can be explained by market conditions and fund flows.
“JNK had tended to trade at a premium in the early months of 2012 when inflows were high in a period of strong risk appetite. That premium has shrunk more recently amid weaker risk appetite and the ETF has been trading closer to its ask price,” according to the FT report.
Investors seeking extra yield have pumped billions of dollars into junk bond ETFs this year.
However, high-yield mutual funds and ETFs recorded net outflows of about $2.5 billion for the week ended May 23. The week saw the fourth-largest outflow from junk bond funds since 1992. [Are High-Yield ETF Flows Reversing After Buying Spree?]
‘Liquid alternative’
Other junk bond ETFs include iShares iBoxx High Yield Fund (NYSEArca: HYG), PowerShares High Yield Corporate (NYSEArca: PHB) and PIMCO 0-5 Year High Yield Corporate Bond (NYSEArca: HYS). [High-Yield Bond ETFs]
Matt Tucker, head of the iShares fixed-income strategy team, said the controversial trading in high-yield ETFs has been misunderstood by some market participants.
“Large investors wanted to own a diversified portfolio of high yield bonds, so they bought up shares of a high yield ETF on the exchange, and then redeemed the shares of the ETF for the underlying bonds. This is exactly what HYG and our other high yield iShares ETFs are designed to do – provide a liquid alternative to the over-the-counter bond market,” he said in a blog post.
SPDR Barclays Capital High Yield Bond ETF
