ETF mythbusting: High yield ETFs are not distorting the bond market

Jul 23rd, 2019 | By | Category: Fixed Income

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By Matthew J. Bartolini, Head of SPDR Americas Research, State Street Global Advisors.

Matthew J Bartolini, Head of SPDR Americas Research

Matthew J Bartolini, Head of SPDR Americas Research.

Have you heard the myth that high yield ETFs are exacerbating market sell-offs? Yup, me too—far too many times.

This blame game, repeated after almost every substantial market stumble, typically centres on the thesis that high yield ETFs are creating a systemic threat to the bond market by providing liquidity to an illiquid market.

Another common complaint is that they dominate trading volumes and are unduly pushing around the underlying high yield market.

Let me set the record straight: this myth is misguided. High yield ETFs represent a small portion of trading volumes and assets, and as I will discuss here, they have been shown to have little impact on underlying individual bond prices.

Instead, time and again, high yield ETFs function as intended in periods of market stress, offering liquidity and price transparency to an entire asset class in a single, efficient vehicle.

Evaluating high yield ETF’s impact: Be sure to hit the right volume button

High yield ETFs are uniquely structured to offer two levels of liquidity—primary market liquidity and secondary market liquidity. But confusion about this liquidity and resulting trading volumes can spark accusations that high yield ETFs are influencing the price of underlying high yield bonds.

For a refresher, primary market activity refers to the creation and redemption of ETF shares. Trading on the secondary market entails the buying and selling of existing ETF shares. Secondary market transactions do not always result in the creation or redemption of ETF shares. In fact, the ratio of secondary to primary activity for the entire high yield ETF industry—as defined by Bloomberg Finance—is 5:1. This means that for every $5 traded on the secondary market, only $1 is created or redeemed.

When myths about high yield ETFs arise, this ratio is the single greatest retort to the claim that it is hazardous to provide liquidity to an illiquid asset class. It clearly illustrates that only a fraction of all high-yield ETF trades touch the asset class. Meanwhile, as a result of the liquidity provided by the secondary market, investors can transfer risk, modulate exposure, and tailor portfolios with precision and efficiency using just one vehicle—an ETF.

A deeper dive into the primary market

As the example above shows, comparing secondary market high yield trading volume to underlying high yield single cash bond trading volume is not an accurate method to gauge the impact of ETFs. Instead, to decipher the effect that high yield ETFs have on the underlying cash bond market, you need to study primary market notional activity, which leads to the purchase or sale of individual high yield bonds. So, what does this entire high yield picture look like?

The chart below puts high yield trading volumes in perspective. Over the last year, the total trading of high yield single CUSIP bonds—or individual securities—has averaged $11bn a day. Secondary market ETF volume stands at $2.3bn; however, remember this figure reflects transactions between two parties of already created ETF shares. When it comes to the average daily notional activity that impacts underlying bond prices—the primary market ETF creation or redemption activity—the number stands at just $418m.

Source: SPDR ETFs.

Drilling down, the chart below captures the activity initiated by ETFs from a creation or redemption on single CUSIP bonds. It is very small. Over the past 10 years, the median was 1.96%, while in the past five years, the median was 2.95%. The max share was 5.9% in early 2019.

Source: SPDR ETFs.

The key takeaway: Secondary market volume is not the metric to look at when dissecting ETF impact on the cash bond market. Primary market volume is, and the small size (approximately 2.95% currently) of primary market notional activity from high yield ETFs touching the single CUSIP high yield bond market is not likely to drive or dislocate the entire high yield bond market.

High yield ETFs and market sell-offs: A real-world example

While averages and medians are useful, a real-world example— such as high yield ETF performance during market sell-offs in February and in the fourth quarter of 2018—might be more telling.

During the February market sell-off, high yield ETFs were in the midst of a two standard deviation fund flow event. In the past decade, average high yield monthly flows have held steady around $800m. However, in February, the asset class saw nearly $3bn of outflows. Despite this selling activity, the share of primary high yield ETF market activity to underlying high yield cash bond volume touched only 3.4%.

This is an ideal case study to highlight the virtues of high yield ETFs. Over the course of five months, nearly $66bn of notional ETF volume was traded on the secondary market and $7bn in assets under management left the ETF asset class, as shown below.

Yet to the underlying high yield bond market, this was not a gargantuan flood of assets that could lead to a distortion, since it represented such a small share (as noted above). The same held true during the market sell-off in the fourth quarter of 2018. The market was gripped with a sizable drawdown, and not only did ETFs not blow up, they thrived (as shown in the chart depicting trading volumes). The share of secondary market trading volume as a percent of cash bond volume increased to over 40%, evidence of investors turning to ETFs to efficiently express views and transfer risk in real-time—and source liquidity at a time when redemption orders were coming in and client cash flows needed to be met. That latter point reinforces how ETFs are being used tactically by active managers as a cash equitization tool.

Source: SPDR ETFs.

The key takeaway: High yield ETFs lost 28% of their assets at one point, and no one said a word! If they are meant to be this ticking time bomb, how come when they lost more than a quarter of their assets, did the high yield market not freeze up with funds unable to meet redemptions?

The reason lies within the structure. The creation/redemption mechanism allows for an efficient trading environment in which the majority of investor behaviour is fulfilled on the secondary market, with buyers and sellers clearing trades at the fair market price. And the next time someone says fixed income ETFs—in particular, high yield ETFs—haven’t been tested, remember that they withstood a nearly 30% loss of assets in one year, all while providing clients efficient and liquid market access without disruption. Test passed.

High yield ETF myth busting

Sometimes old myths die hard, and the tale that high yield ETFs are distorting the underlying high yield bond market—especially in times of turbulence—is one of them. I’ll continue to debunk high yield ETF myths in the next blog in this series, and I’ll explain how these ETFs can be helpful in a portfolio.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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