If interest rates were to quickly rise, high-yield bond exchange traded fund investors may find it costlier to sell-off their positions as notoriously low liquidity in the speculative-grade debt market could cause problems for the ETFs.
Fixed-income observers are worried that investors will rush en masse at the last second to sell bonds in response to rising interest rates, Reuters reports.
Wall Street banks would have been able to soften the blow and buy these bonds. However, due to new regulations and capital requirements imposed following the financial crisis, these same banks could be forced to cut inventories as well.
“I look around and ask ‘at the end of the day how easy would it be to sell what I own?’, and the answer is it is much more challenging,” Jason Brady, a fixed income portfolio manager at Thornburg Investment Management, said in the article.
Higher quality, investment-grade debt securities have historically remained a more liquid area in the fixed-income market. However, less liquid speculative-grade debt securities could become vulnerable ahead. Firms like Voya Investment Management, which uses third party managers to subadvise its funds, are giving high-yield bond managers up to three days notice before issuing large redemption orders to make sure they can execute the trades in a timely fashion.
“Liquidity is illusory for most bonds,”Margie Patel, senior portfolio manager at Wells Capital Management, said in the article. “The only time you need it is when you can’t get it.”
While the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK), the two largest high-yield bond ETFs, have attracted new inflows as a more liquid alternative to junk debt securities, an ETF’s true liquidity is still limited to their underlying markets. [Fixed-Income Traders Increasingly Rely on Junk Bond ETFs]
In this case, some fixed-income observers are concerned that the low liquidity in the junk debt market could cause problems in junk ETFs if a large sell-off were to occur. For instance, selling pressure in the ETF may not be perfectly reflected by the illiquid underlying market, creating widening tracking errors between the ETF’s price and net asset value.
Additionally, some are growing concerned about liquidity in bank loan funds, which hold non-investment-grade company debt, since these types of loans can take weeks to settle. In the ETF space, investors can monitor the passive index-based PowerShares Senior Loan Portfolio (NYSEArca: BKLN) and Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN). There are also two actively managed options, including the SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) and First Trust Senior Loan ETF (NasdaqGM: FTSL).
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.