ETFs up volatility in HY market

The US high-yield market is poised to become intrinsically more volatile going forward as increased participation by exchange traded funds, mixed with shrinking dealer inventories, become the norm.

ETF growth is skyrocketing as investors seek attractive higher-yielding instruments. Currently, ETFs make up US$25.9bn of a total US$143bn in high-yield assets under management on a weekly dataset basis, according to Lipper FMI. (Including monthly reporting funds, total assets rise to US$241bn). This compares with US$20.4bn at the start of the year, US$13.9bn at the end of 2010 and just US$8.4bn at the end of 2009.

While this still represents a small portion of the overall market, ETFs have had a noticeable impact, with their growth contributing to spread compression and a significant portion of weekly inflows. Recent tightening – the option-adjusted spread on the Barclays Capital high-yield index moved in to 612p from 682bp at the start of the year – is partly due to ETF involvement, market participants say.

Because large, liquid names, whether new issues or fallen angels, are likely to be included in indices when they are rebalanced each month, and by their nature ETFs will have to include them in their portfolios, those credits are getting bid up by everyone in the market.

“The ETFs have had such significant inflows that just about every name that qualifies for an ETF has more of a bid than non-ETF names. It’s a little self-fulfilling,” said one high-yield strategist.

The amount of recent interest in high-yield ETFs has been noteworthy. A total of 42%, or US$4.6bn, of the US$10.9bn in high-yield inflows for the year through to February 8 have come through ETFs. This compares with 36% or US$5.6bn of full-year 2011’s US$15.6bn inflow, according to Lipper FMI.

Furthermore, weekly inflows themselves have increased significantly in size in large part because of the increasing ETF market, with eight of the largest nine weekly high-yield inflows having occurred since the fourth quarter of 2011.

Down market?

The concern, however, is just what will happen in a down market. As quickly as investors have piled into the market through ETFs, a down cycle could cause a dramatic exodus, with much larger expected outflow numbers causing a stampede effect.

“The ETFs have had such significant inflows that just about every name that qualifies for an ETF has more of a bid than non-ETF names. It’s a little self-fulfilling”

And when ETFs become sellers through their approved participants, they could help drive prices even lower.

“In up markets, when money is coming in, ETFs have to buy right away. [Traditional] funds don’t need to buy right away,” said another high-yield strategist. “The greater risk is in down markets when ETFs are sellers. You definitely will have a little more volatility and that is probably exacerbated by the fact that overall liquidity is thinner.”

Inventories fall

As a result of the elimination of proprietary trading by banks in anticipation of the Volcker Rule, dealer inventories have dropped dramatically, leading to much lower liquidity, and support, in the market. According to the Federal Reserve Bank of New York, corporate debt inventories dropped to US$43bn as of February 1, a level not seen since 2003 and less than one-fifth of the US$235bn high recorded in October 2007.

“Dealer inventories have come down drastically, not just in high-yield but in general for corporate credit,” said one banker. “With inventories coming down on the Street, there is no buffer – meaning if the buyside wants paper, we don’t have the inventory to satisfy that demand and the market just rockets higher.”

This is especially concerning during down cycles, said the banker, as the market can drop just as quickly and as severely. If this is exacerbated by massive outflows and redemptions from ETFs, participants could be in for some choppy times. Traditional investors are bracing for the impact.

”Volatility is not always a bad thing,” said John Fekete, portfolio manager at Crescent Capital. “But it has increased due to the growing influence of ETF assets and I think it’s something that is here to stay. Long-term investors need to be aware of this and I believe this explains why we’ve seen these pretty sharp swings in the market month-over-month.”

According to CreditSights, the two largest ETFs, HYG and JNK, account for 95% of the assets of the eight existing index-benchmark ETFs, although the number of ETFs is growing, with at least two high-yield focused funds in the registration process.