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Irregular use of ETFs by institutional investors is credit negative for sponsors

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On 10 May, State Street Global’s high yield bond exchange-traded fund, SPDR Barclays Capital High Yield Bond ETF (trading on the New York Stock Exchange as JNK) experienced an in-kind redemption of 19.7 million shares (USD780 million), giving an investor control of bonds directly from the fund’s portfolio. This sizeable trade was unusual, and it signifies institutional investors’ increasing use of ETFs that have long been marketed to retail investors, says Moody’s.

Normally, investors trade ETF shares in the secondary market. Institutional investors, typically market makers, may trade directly with a fund through in-kind transactions of 100,000-share blocks known as ‘creation units,’ which are exchanged for baskets of securities replicating the fund’s benchmark.
 
The rising institutional use of ETFs is credit negative for ETF sponsors such as BlackRock Inc. (A1 stable), with its iShares, Invesco, Ltd. (A3 stable), with its PowerShares, and State Street Corp. (A1 stable), with its SPDRs, because retail investors and their advisors would be deterred from holding ETFs if they are exposed to elevated volatility and execution risk from large trades. In addition, such transactions elevate the potential for additional regulatory scrutiny and increased compliance costs for these products if their use as vehicles for implementing arbitrage strategies proves to amplify systemic risks.
 
Large block trades appear to have affected the relationship between JNK’s price and net asset value (NAV), causing investors trading losses. ETFs theoretically track the value of their underlying securities baskets. Subsequent to the large trade in JNK, an additional 14.4 million shares were extinguished, shrinking by 13.4% net assets of the fund overall through last Wednesday. In the face of this selling pressure, the fund’s price declined 2.7% and its price to NAV ratio sharply dropped to a discount of 127 basis points (bps) on 17 May; through 9 May, it had averaged a 40 bp premium for the year. This collapse in premium would have cost an investor a substantial portion of the year-to-date total return of the ETF, which was 5.9% through 30 April.  Click here to access the full article or see attached file.

 

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