Courtesy of Paul Amery, IndexUniverse.eu
On a longer-term view, last month’s US$1.3 billion net outflow from high-yield bond ETFs looks like nothing more than a blip.
Fixed income trackers are currently the fastest-growing sector of the ETF market and, within that category, high-yield (or “junk bond”) funds have recently attracted the greatest interest. The two largest US-listed funds of this type, iShares’ iBoxx $ High Yield Corporate Bond ETF (NYSE Arca: HYG) and State Street’s SPDR Barclays Capital High Yield Bond ETF (NYSE Arca: JNK) have added around US$10 billion in new assets since October, taking their combined size to nearly US$25 billion.
High-yield ETFs now constitute around 3 percent of the overall junk bond market and generate around 10 percent of the daily trading volume in such bonds, one market observer told IndexUniverse.eu.
ETF evangelists talk of the transformational role being played by such funds in what is traditionally a relatively illiquid sector of the market.
“We’re bringing a revolution to the high-yield bond market by increasing liquidity and pricing transparency,” a senior executive at one ETF issuer told IndexUniverse.eu last month.
“In this prolonged low-rate environment, we continue to see investors turn to high-yielding alternatives…and we’ve cautioned investors accordingly about reaching for yield,” says Vanguard’s CEO, Bill McNabb.
On the face of it, publicly available data support ETF managers’ contention that their funds can offer superior liquidity to the underlying bond markets.
iShares’ flagship European high-yield bond ETF, the €1 billion Markit iBoxx Euro High Yield Bond fund (LSE: IHYG), has traded on its primary (London) listing with an average bid-offer spread of 31 basis points since the fund’s inception in September 2010. By comparison, the weighted average bid-offer spread on the constituent bonds of the ETF’s underlying benchmark, the Markit iBoxx Euro High Yield index, has averaged over three times more during the same period, at 95 basis points.
Trading Costs For IHYG And Its Underlying Index 
Source: London Stock Exchange Weekly ETP Statistics (no spreads were calculated between February and May 2011); Markit
The comparison between the ETF and the index is not entirely like-for-like: the London Stock Exchange’s weekly bid-offer spread calculation for IHYG is time-weighted and uses all available “tick” data from the exchange’s continuous trading session, while Markit’s monthly index spread calculation is based on a single daily snapshot (taken at 4.15pm, towards the end of each trading day). But on the basis of these two measures of liquidity, the ETF has traded since its 2010 launch with bid-offer spreads that are consistently lower than those on the portfolio of bonds constituting the index.
It’s noticeable that in early August 2011 the ETF and index spreads temporarily converged. During the week of August 8-12, both ETF and index fell by 4 percent in price, as increasing tensions in the eurozone had a knock-on effect on the corporate credit markets.
Apart from that single week, however, the ETF’s spreads have been tighter than those of the index, with the divergence increasing over time. The index’s spread has retreated from the 140 basis point level recorded in October and November last year but has not returned to the 60-70 basis point spreads seen during the first few months of 2011, and remains above 1 percent. But in February and March this year, IHYG’s spreads did retrace to the 15-20 basis point lows of late 2010/early 2011.
One reason for this divergence may be the accelerating inflows into high-yield bond ETFs since late last year, which have led to many more market makers quoting prices in these funds, in turn keeping spreads tight. Indeed, from late September 2011 to the end of April 2012 IHYG experienced only positive weekly net cash flows, with the fund’s net assets more than doubling during the seven-month period.
Outside the high-yield ETF’s secondary market bid-offer spread stands a wider (and invisible) band between theoretical buying and selling prices, reflecting the costs of creating and redeeming the fund in the primary market.
iShares charges a variable cost to market makers looking to create units of IHYG, Alex Claringbull, a managing director at the ETF issuer’s parent, BlackRock, tells IndexUniverse.eu, with the cost given as a spread in basis points above the fund’s net asset value. This creation cost has come down from around 150 bp in September 2011 to 60bp more recently, says Claringbull. iShares charges a smaller cost (typically 10-20 bp) to redeem the ETF, he adds, with the smaller spread on the “bid” side being explained by the fact that the fund’s net asset value calculation (as well as that of the index) is based on valuing underlying bonds at their bid, rather than mid- or offer prices.
Earlier this year, adds Claringbull, iShares also started to offer market makers the facility to create IHYG “in-kind”, rather than only using cash: under the in-kind model, traders ask iShares what bonds it will accept to create the fund, with the fund manager then specifying either the whole basket of index bonds or a subset of them.
But while the fund’s primary market creation and redemption costs have only occasionally been reflected in the ETF’s secondary market spread, at times the fund’s price can move from the top to the bottom of the primary market “fair value” band (and back again) as a result of changes in demand and supply.
IHYG Premium/Discount To NAV (click to enlarge)
Source: Bloomberg
IHYG has traded with an average premium of 0.8 percent to its net asset value since inception, with the premium usually capped at around 1.5 percent (a level that has reflected the typical cost of creating the fund). Periodically, though, the fund has moved to a discount, notably in August, September and November 2011. In recent weeks, from mid-April to late May, IHYG’s premium again disappeared, reflecting a move to net investor selling of the fund after several months of inflows.
So while secondary market spreads in high-yield ETFs may remain tight, it’s still important to work out where the ETF is trading in this theoretical band between primary market creation and redemption prices, Samu Lang, chief investment officer at Taaleritehdas Asset Management, told delegates at the recent Inside ETFs Europe conference.
The firm decided to sell some of its holding of IHYG in April, and by executing the sale on-exchange and via direct “risk” prices from market makers, rather than leaving an order to trade at fund NAV, Taaleritehdas ended up getting substantially better execution: an average sale price of 102.15 rather than 100.72 for a NAV order, Lang explained.
However, he continued, the calculation of a fund’s indicative net asset value (iNAV) is much more difficult in less transparent areas of the market, such as corporate bonds, than, for example, in an ETF tracking a widely followed equity index. It’s important to know how both the index and ETF are being valued (such as whether bonds are valued at bid prices) and what the creation and redemption costs are before placing a trade in such less liquid ETFs, Lang concluded.
And this is where members of the general public, all potential buyers of high-yield bond ETFs, appear to be at an informational disadvantage to those closer to the market. ETF issuers typically do not publish either creation or redemption costs, nor do they make public the constituents of the baskets they accept for in-kind creations and redemptions. iShares, however, says its capital markets team welcomes calls from investors seeking guidance on any fund’s current valuation and how best to place trades.
One planned structural reform, long on the wish-list of regulators, might help increase market visibility. In recent years there’s been a push for a greater proportion of bond trading to take place on more transparent, centralised platforms, and away from the bilateral, voice-based trading that’s still typical.
But such platforms are taking time to materialise. Goldman Sachs’ planned launch of an electronic crossing network for bonds, called GSessions, was recently delayed, while BlackRock remains tight-lipped about a similar project, declining to comment to IndexUniverse.eu on the subject.
In the meantime, the huge inflows into high-yield bond ETFs suggest that these funds are increasingly serving the role of a proxy for the overall asset class. But it will probably take a market cycle or two to judge whether such ETFs play a transformational role in bringing liquidity to a traditionally illiquid area, or whether their increased tradeability is more a reflection of recent yield-seeking from income-starved investors.