Bloomberg News

Exchange-Traded Junk Funds Roil Bond Market as Retirees Jump In

January 25, 2012

Jan. 13 (Bloomberg) -- Funds that give everyone from retirees to institutional money managers easier access to junk bonds are fueling the biggest price swings in more than two years after their buying power surged 10-fold.

Exchange-traded funds that track high-yield bond indexes exceed $22 billion, up from about $2 billion three years ago. While that’s just 2 percent of the $1 trillion in U.S. corporate speculative-grade debt outstanding, ETFs are among the biggest holders of benchmark securities, including those of Las Vegas- based casino owner Caesars Entertainment Corp. and HCA Inc.

ETFs, which drew Congressional scrutiny last year as more complex and riskier versions emerged, are adding to volatility because of rules that promote trading. A measure of price swings for junk bonds was seven times higher in November than May, making it harder for the neediest borrowers to raise capital. Their influence in the market for high-yield, high-risk debt is becoming similar to what ETFs, which have grown to $1.5 trillion from $109 billion in 10 years, have done in other assets.

“These large concentrations of holdings have a dramatic impact on individual issues,” said Jason Rosiak, the head of portfolio management at Pacific Asset Management, the Newport Beach, California-based affiliate of Pacific Life Insurance Co. which oversees $2.9 billion. “When the market is up the offers on these issues will be higher and conversely when the market is lower, or there are expected outflows, bids dry up quickly or are lower on the names held in the ETFs.”

Relative Returns

While cash has poured into ETFs, they haven’t outperformed. New York-based BlackRock Inc.’s $11.6 billion iShares iBoxx High Yield Corporate Bond Fund, which started in April 2007, has returned a cumulative 28.2 percent since inception, with dividends reinvested. A $9.26 billion in assets ETF from State Street Corp. in Boston has returned 25.6 percent since December 2007, the month after it was created.

Speculative-grade bonds on average returned 40 percent since April 2007, compared with 36.3 percent for investment- grade debt and 37.3 percent for U.S. Treasuries, according to Bank of America Merrill Lynch index data.

ETFs allow individual investors to speculate on debt ranked below investment grade -- less than Baa3 at Moody’s Investors Service and BBB- at Standard & Poor’s, without owning the bonds. Unlike mutual funds, whose shares are priced once daily, ETFs are listed on exchanges and are bought and sold like stocks.

The average default rate the past five years for speculative-grade bonds was 4.67 percent, compared with 0.2 percent for investment-grade debt, according to Moody’s.

High Rates

With the Federal Reserve saying it will keep benchmark interest rates near zero through at least mid-2013, ETFs are gaining in popularity with individuals. The average rate for a new one-year certificate of deposit offered by major banks dropped to 0.76 percent on Jan. 4, down from 2.5 percent in 2010, according to Bankrate.com. Junk bonds yielded 8.3 percent as of yesterday, Bank of America Merrill Lynch index data show.

Newport Beach, California-based Pacific Investment Management Co., owner of the world’s biggest bond mutual fund, started an ETF in June that buys junk bonds tracking a Bank of America Merrill Lynch index.

As ETFs focusing on bonds grow, so have prices swings in fixed-income securities. A measure of volatility over 30-day periods for the Finra’s Active High Yield U.S. Corporate Bond Index rose to as high as 11.1 in November, from 1.5 in May.

The BlackRock and State Street ETF’s own a combined 7 percent of Caesars’ $3.3 billion of 10 percent notes due in 2018, making them the biggest holders among money managers that disclose positions, according to data compiled by Bloomberg.

Bond Gyrations

As Europe’s debt crisis erupted last year, causing a sell- off in assets worldwide and an 11 percent drop in the BlackRock fund’s share price, the Caesars bond plunged to as low as 54 cents on the dollar on Oct. 4 from about 90 cents at the end of July, Trace data show. It jumped to 70.6 cents by yesterday as the ETF climbed to $89.12 a share from $81.05 on Oct. 4.

The BlackRock and State Street ETFs own 7.3 percent of hospital operator HCA’s $3 billion of 6.5 percent bonds due in February 2020, Bloomberg data show. Those bonds have traded from as low as 93.75 cents on the dollar on Aug. 8 to a high of 105.6 cents on Oct. 28, Trace data show. Six times since the bonds were sold in July, they have swung in price by at least 6 cents within about a one-month period.

“Uncertainty breeds volatility,” said Kevin Quigg, the global head of strategy and consulting at State Street’s ETF group. “The volatility that’s being expressed in the marketplace is much more reflective of what’s going on in the broader marketplace.”

ETF Transparency

Such price swings aren’t being created by ETFs, only made transparent, said Matt Tucker, the head of iShares Fixed Income Strategy at BlackRock.

The fund “has made the high-yield market visible for the first time for investors,” Tucker said. “They hadn’t realized that the high-yield market was that volatile. It was always that volatile; it just wasn’t that easy to see.”

Quigg said bonds bought by ETFs are screened to ensure that the securities can be easily traded without prices being pushed around by the funds. “There’s a safeguard against the investment vehicle affecting the broader market,” he said.

Average daily trading in the two largest high-yield ETFs more than tripled to $304.4 million last year from $95.5 million in 2009, even as the volume of junk bonds exchanging hands shrunk 16 percent to $2.83 billion, according to data compiled by Bloomberg and Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, or Finra.

Dealer Reliance

ETFs are different from mutual funds in that their managers don’t actively buy and sell bonds themselves. Instead, dealers purchase and dispose of securities on their behalf based on demand for shares in the funds. The bonds that are then exchanged for shares in the ETF largely mirror the indexes that the ETFs seek to track.

Traders from hedge funds to bond dealers are increasingly tracking the daily activity of ETFs, with some looking for ways to profit by speculating on which bonds will be sold or bought. Others seek to make money on abnormally wide gaps between where ETF shares trade and the market prices of the bonds they own.

“There’s a growing number of groups that are out there doing the ETF arbitrage,” said Peter Tchir, founder of New York-based hedge fund TF Market Advisors. “That’s a pretty good development for the market. It will add to the volatility, but it also encourages” trading by both buyers and sellers, he said.

‘Get Hit’

The rise in ETF assets and related trading activity is generating concern that bonds held by the funds are making them more susceptible to wider price swings because junk-rated securities are thinly traded compared with equities and have relatively wide differences between bid and offer prices, according to Rosiak.

“The market can recognize based on expectations of inflows and outflows what names there will be demand for, or what names there will be supply for,” Rosiak said in a telephone interview Jan. 10. So, as near-term volatility rises, speculation increases that money flowing out of or into ETFs will accelerate, causing bonds held by the funds to “get hit or bid up first,” he said.

As ETFs globally surpassed $1 trillion in assets in 2009, regulators stepped up scrutiny.

The U.S. Securities & Exchange Commission has examined whether ETFs that use derivatives to amplify returns contributed to equity-market volatility in August and on May 6, 2010, when the Dow Jones Industrial Average plunged almost 1,000 points in an hour and bounced back just as quickly. The regulator said in March 2010 it wouldn’t approve new ETFs that make substantial use of derivatives.

Gold ETFs

ETFs that buy and sell commodities futures gained attention because of the risks from contango, in which the cost of contracts with longer expiration dates become more costly than those with nearer-term expirations. That erodes a fund’s value because fund managers have to sell commodities futures before they expire and buy new ones to avoid taking delivery of the raw materials they’re tied to.

Investors in exchange-traded products backed by gold own 2,357.3 metric tons of the metal, more than the amount held by all except four central banks, Bloomberg data show.

During a Senate Banking subcommittee hearing on the funds in October, Senator Jack Reed, a Democrat from Rhode Island and chairman of the subcommittee, questioned whether critics were correct in calling them the “new weapons of mass destruction.”

BlackRock’s Pledge

BlackRock, which manages $1.2 trillion of fixed-income assets and is the biggest provider of ETFs, has urged lawmakers to bar funds that rely on derivatives from being marketed as ETFs. The firm doesn’t use derivatives in its junk-bond ETF.

During an investor call in October, BlackRock Chief Executive Officer Laurence D. Fink said the industry risked following the downfall of the mortgage-bond market, where once- simple products that companies such as his pioneered evolved into complex variations with risks investors didn’t understand.

“That was a failure of the mortgage market,” Fink said during the Oct. 19 conference call with investors. “We need to be very assertive as a firm and outspoken that we will not allow, at BlackRock, the lack of disclosure on these products.”

Even if high-yield bond ETFs are driving volatility, the added transparency and greater trading activity will benefit the market, said Tchir.

“One of the things that always used to be true of high- yield was it would show very low volatility, but it didn’t really trade so it was kind of a fake low volatility,” he said. “The market would just shut down.”

Price Dislocations

Now funds are exploring trades such as buying or selling the ETF shares while taking the opposite bet on the underlying bonds, earning a profit when the two converge. Such dislocations emerged last month as the price of BlackRock’s iShares ETF shares soared to as high as 2.6 percent more than the fund’s net asset value on Dec. 27. The premium shrunk to 0.9 percent on Jan. 11.

A similar trend developed after indexes of credit-default swaps were created last decade, allowing traders to arbitrage the gaps between the indexes and the underlying bonds or contracts on individual companies in the benchmarks.

The swaps indexes “created this whole new class of traders,” Tchir said. “It kept the price fair.”

Performance of the funds hasn’t kept up with the market, trailing their benchmarks since their inceptions. BlackRock’s ETF has underperformed its index each of the past three years, trailing by as much as 3.8 percentage points as the market recovered in 2009 from the collapse of Lehman Brothers Holdings Inc., according to the fund’s website.

State Street’s SPDR high-yield ETF has returned an annual 6.07 percent since inception, compared to 9.2 percent in its benchmark, the Barclays Capital High Yield Very Liquid Index.

“It’s very hard for an ETF to beat the index, and even the average manager, considering how much forced trading an ETF has to do in a relatively illiquid market,” said Gershon Distenfeld, who oversees high-yield credit investments at AllianceBernstein LP in New York.

--With assistance by Christopher Condon in Boston. Editors: Philip Revzin, Robert Burgess

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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