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.