Reviewing the Liquidity of Junk Bond ETFs

Through the years of the Federal Reserve’s zero interest rate policy, exchange traded funds swelled in popularity among advisors and investors. That much is evident by the combined $23 billion in assets held by the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK).

But with the Fed likely on course to raise interest rates before the end of 2015, investors are once again questioning the ability of junk bond ETFs to endure a potential sequel to the taper tantrum of 2013. 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.

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. [Fixed-Income Traders Increasingly Rely on Junk Bond ETFs]

Year-to-date, JNK has added $225.4 million in new assets while HYG has bled over $841 million, but during the second quarter, the two largest junk bond ETFs lost over $4.5 billion combined.

“Thus far, the two most popular ETFs have handled the increase in asset outflows quite well. Since the beginning of May, more than $3.1 billion has been redeemed from iShares’ HYG, which currently has about $13.4 billion in net assets. SPDR’s JNK, which has about $9.8 billion in total assets, saw outflows of more than $1.5 billion over the same trailing two-month period. These outflows, of course, are a measure of activity in the primary market. Fixed-income ETFs, like HYG and JNK, have essentially provided an additional layer of liquidity to the markets by bringing bonds, which trade over-the-counter, onto the exchange where investors can transact in the secondary market without disturbing the underlying portfolio of bonds,” according to a recent Morningstar research piece.

As investors found it more difficult to price fixed-income securities, many have turned to ETFs for their greater perceived liquidity. The potential problems ahead are associated with large redemptions in the ETFs or secondary markets. If enough people exit the funds, the ETF providers will have to swap shares for bond securities in the primary market. However, if there is not enough bond securities in the underlying market to meet redemptions, ETF investors may not be getting what they bargained for. [How ETFs Are Traded]