This year, the high yield corporate bond market has been an attractive asset class for investors searching for yield in an environment where government bonds offer little value. The emergence of Exchange Traded Funds (ETFs) has given investors a liquid and convenient way to access this market. Unfortunately, the popularity of these instruments may have destabilising consequences and increase volatility on issuers normally considered the stalwarts of the asset class.
ETFs resemble index tracking funds (the main differences are liquidity and fees - ETFs trade like stocks and tend to have low fees). When ETF investors buy or sell, the manager sells assets to cover the redemptions. When markets are weak, only the most liquid issuers can be sold at reasonable prices.
The mismatch in liquidity between the fund and the underlying holdings is bad for the ETF investor as significant creation or redemption activity makes the fund’s price a poor reflection of the portfolio’s underlying value and does not reflect the high trading costs in an illiquid market. It could also be damaging to the underlying asset class and may make high yield investors wary of investing in the issuers contained in an ETF basket.
In the last month high yield ETFs have seen the two largest weekly outflows ever, according to data from Lipper – a bad omen or a buying opportunity?