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Morningstar research examines high-yield bond ETFs

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Morningstar has released new research about the trading activity of the most heavily traded high-yield bond ETFs domiciled in the US and Europe and finds evidence for the positive role of high-yield bond ETFs as a stress valve during market stress. 

The paper, "High-Yield Bond ETFs – A Primer on  Liquidity", offers comprehensive analysis of the high-yield bond ETF market, questions the vehicle’s presumed role in market instability, and outlines the crucial differences between the ETFs’ primary and secondary layers of liquidity.

According to the paper, global assets held in high-yield bond ETFs total USD 51 billion. Secondary market trading on an exchange, meanwhile, is the norm for US-domiciled ETFs. For those domiciled in Europe, over-the-counter trading is prevalent with up to an estimated 70 per cent of trading taking place off an exchange.

ETF trading in the secondary market appears not to have a one-to-one effect on the underlying high-yield bond market: since 2008, the median secondary/primary market ratio for the US-domiciled iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has ranged between five and eight. This means that between 5 and 8 U.S. dollars were traded between holders of existing ETF shares in the exchange before the ETF manager had to purchase or sell a single US dollar worth of high-yield bonds to meet creations or redemptions from the fund. During the same period, the median ratio for SPDR Barclays High Yield Bond ETF (JNK) ranged between three and five.

Adjusting for heavy OTC trading, the most popular European-domiciled high-yield ETFs—iShares iBoxx Euro High Yield Corporate Bond (IHYG), iShares iBoxx $ High Yield Corporate Bond ETF (SHYU), and Pimco Short-Term High Yield Corporate Bond Source ETF (STHY)—also show healthy median secondary/primary market activity ratios.

In times of market stress in the underlying high-yield bond market, secondary/primary market ratios for the ETFs spike considerably above their median range values. This indicates that heavy trading of ETFs in these periods has been largely netted off between holders of existing ETF shares, without unduly impacting the liquidity of the underlying high-yield bond market. 

A liquidity crunch in the underlying high-yield bond market would affect any investor in the asset class, irrespective of vehicle. An investor’s ability to continue trading in the secondary market would determine the consequences for holders of existing high-yield ETF shares.

“In conducting this research, our aim is to demonstrate whether certain concerns expressed about high-yield bond ETFs can be justified,” says Jose Garcia-Zarate, Senior ETF Analyst for Morningstar’s European Passive Fund Research team. “The visibility of heavily traded high-yield bond ETFs has made them an easy target for criticism, often cited as a factor in market volatility and hard to exit in times of market stress.

“Our analysis suggests that far from being agents of instability, high-yield bond ETFs have acted as a safety valve, allowing investors to express their investment views without unduly affecting the underlying market. The bulk of secondary trading is regularly netted off between buyers and sellers of existing ETF shares,” Garcia-Zarate adds. “High-yield bonds are clearly not free of risk. However, we feel it is important not to cloud what would be a welcome debate about the fundamentals driving investors to an asset class formerly known as “junk bonds” with ill-informed judgments about ETFs as the chosen vehicle for investment.”  
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