(Bloomberg Opinion) -- It’s been a month to forget for U.S. risky assets. Sure, stocks get much of the attention, but it’s been just as bad for the best-performing part of the bond market: junk-rated corporate debt.
Yields on bonds rated below investment grade are the highest since November 2016, jumping to 6.61 percent on Wednesday from 6.18 percent on Oct. 1, according to Bloomberg Barclays index data. They’ve already lost more than 1 percent in October, on pace for the worst monthly performance in almost three years.
Here’s the thing: It could have been a lot worse.
Sure, investors pulled about $5.4 billion from high-yield funds between Oct. 4 and Oct. 9, the largest withdrawal since February and the fourth largest on record, according to a report this week from JPMorgan Chase & Co. And yes, exchange-traded funds lost $1.6 billion on Oct. 9 and $1.4 billion on Oct. 5, the two largest daily outflows on record.
But digging deeper into BlackRock Inc.’s iShares iBoxx High Yield Corporate Bond ETF, the biggest of its kind, reveals a different story. It shows how the advent of these frequently traded funds of illiquid junk debt may actually improve the health of the overall market in volatile times.
As the markets buckled, trading volume surged in the iShares fund, known by the ticker HYG. More than 37 million shares exchanged hands on Thursday, the most for a day since February. It’s hardly a coincidence that the S&P 500 Index also fell by the most since that month on Wednesday.
Just on its own, the surge in volume would be valuable. The fund’s significance goes beyond that, though. It has increasingly become a way for high-yield investors to hedge their bond positions or for speculators to outright wager that the market is overvalued. The absolute amount of short interest in HYG is at a record high. As a percentage, short interest is more than 60 percent and over twice as high as any other fixed-income ETF tracked by Bloomberg.
This is nothing short of validation for bond traders including Krishna Memani, head of fixed income at OppenheimerFunds Inc. As a reminder, here’s what he told me a couple of months ago, when high-yield bonds ruled the debt markets.
“The ETF market, which was supposed to subtract liquidity from credit markets, is actually adding liquidity by aggregating the risk and bringing in people who want to take macro risk as opposed to micro bond level risk,” he said in an interview. “The ETF market ends up providing the live bid-ask spread that even the credit markets themselves cannot generate.”
And wouldn’t you know it, that’s precisely what happened. In fact, the price on HYG has stabilized, a signal that perhaps the worst is over for now. Either way, the ability to instantly create two-way flow and price discovery in an otherwise slow-moving market is critical for those who own speculative corporate debt and are trying to assess the damage of a rapid change in sentiment.
It’s hard to know exactly who is using HYG and for what specific purpose, but there are clues. Earlier this year, Bloomberg Businessweek profiled Matt Pasts, the manager of BTS Tactical Fixed Income Fund, which invests in junk bonds almost entirely through ETFs. And when Pasts thinks the market is going down, BTS switches to either U.S. Treasuries or cash.
Large institutions are also catching on to the ETF boom. Goldman Sachs Group Inc. is leading the movement, through transactions known as “credit portfolio trades,” Bloomberg News’s Alastair Marsh wrote in July, because it has the power to obtain the underlying assets for ETFs and control the supply of shares. Just this week, Jim Switzer, head of credit trading at AllianceBernstein Holding LP, told the Financial Times that the asset manager is “using the ETF ecosystem to move blocks of risk around.”
That’s not to say ETFs are perfect. Investors are right to be skeptical given the stark difference in liquidity between the funds and the securities they purchase. When defaults are generally low, it’s fine to be a passive investor. But that doesn’t work when large swaths of the high-yield market come under pressure, as energy-related companies did in late 2015 when oil prices bottomed. For every short-seller profiting from a decline in HYG, there’s someone else who’s long — and losing.
But considering that vanishing liquidity remains a boogeyman for credit buyers, it’s hard not to conclude that ETFs have helped the high-yield bond market more than they’ve hurt it.
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Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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