High yield bonds have been getting a lot of attention lately. Between historically low yields and record high prices, these “junk” bonds are looking less junky by the minute. But while some investors don’t feel the reward is worth the risk, others (including Russ Koesterich) believe there are still some compelling reasons to hold high yield.
It was against this backdrop that on Tuesday June 4th, the iShares High Yield Corporate Bond ETF (HYG) – the largest ETF in its category (as of 6/11/13) – experienced its biggest trading day ever. In the course of one session, the fund saw $1.32bn in trading volume, surpassing the $1bn mark for only the second time (the first time was the previous Thursday, with $1.032bn). And while on the balance there were more sellers than buyers and the fund did see $210mm in redemptions, there was still plenty of two-way activity. Let’s dig into the numbers to see what we can learn:
- On average, the entire US fixed income ETF market experiences about 5X as much secondary market trading (e.g. on the exchange) as they do primary market trading (e.g. creations and redemptions). In other words, for every $5 of fixed income ETFs traded on the exchange, there is $1 of corresponding bond trading. The $1 in bond trading represents the excess supply or demand in the market – meaning that in periods of excess supply, shares of bond ETFs are being redeemed, and in periods of excess demand, new shares of bond ETFs are being created.
- HYG, on the other hand, on average experiences about 10X as much secondary market trading volume as primary bond market volume – one of the benefits of being the biggest fund on the block. Stated another way, creations and redemptions for HYG are relatively infrequent because there’s so much volume on the exchange.
- When trading in HYG spiked Tuesday, the fund’s ratio of exchange to bond trading condensed from 10:1 to 5:1. In other words, even with the increased selling pressure, the fund still experienced the average secondary-to-primary ratio for the fixed income ETF category.
One important thing to note is that amidst all this volume, HYG closed at an 81 basis point discount to its net asset value (NAV). The difference is caused by the fact that most high yield bonds do not trade every day, and benchmark values (and most NAV calculations) are generally calculated based on estimates of individual bond prices. In fact, in high yield less than 10% of the bonds trade each day, which means that over 90% of the market is valued using estimates. These estimates incorporate the best available information, but still tend to lag in fast moving markets. In these markets we can see that HYG’s price leads its NAV and market indices, which take a few days to catch up. This is one of the reasons that ETFs like HYG have become an important vehicle through which investors manage their high yield exposure, because they are a real-time access vehicle that reflects current market sentiment.
So what does all this mean and – perhaps more importantly – why should investors care? What I find most interesting about this case study is how nicely it illustrates the power of secondary market trading volume in ETFs. HYG has created additional liquidity for the market, essentially turning $210mm of bond trades into $1.3bn of high yield activity, bringing together a broad range of investor types who can all access the liquidity. Which should be good news for even the most conflicted investor.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.