In December 2015, while most of the world was winding down for Christmas, the exchange-traded fund (ETF) market was mired in a dramatic debate over whether these funds were adding to or reducing the impact of a high-yield bond sell-off.
Frantic selling in the US high-yield ETF market was triggered when Third Avenue Focus Credit Fund announced it was stopping clients from redeeming their investments in the $788m (£541m) high-yield bond fund. In a rare and unnerving move, the mutual fund said it would be forced to wind down due to concerns it would not be able to sell its underlying bonds fast enough to satisfy investors running for the exits, or at prices high enough to pay them back sufficiently.
In a letter to shareholders, chief executive David Barse said: "Investor requests for liquidation... in addition to the general reduction of liquidity in the fixed-income markets, have made it impracticable for Third Avenue Focus Credit going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders."
Amid the panic that followed junk bond ETFs in the US hit their highest ever trading levels. iShares iBoxx $ High Yield Corporate Bond ETF (HYG) hit trading volumes of $3bn on Monday 14 December, compared with an average of $800m a day, according to BlackRock. ETF champions argued that this showed ETFs proving their worth as highly liquid, efficient market tools. But others are worried that if demand for ETF redemptions grows too high, they too would face issues selling the underlying investments they held, and that ETF investors could also find themselves trapped.
Don't panic
There are several reasons not to panic about ETF liquidity. ETFs are traded on the stock market, which means that usually the deals done between buyers and sellers are enough to satisfy demand, and there is no need to buy and sell the underlying stocks in the primary market.
It is still the case that if everyone wanted to sell at once, the ETF would have to sell the underlying stocks. But because ETFs are used as hedging tools by institutional clients, that tends not to be the case, even in times of market trauma. Shaun Port, chief investment officer at Nutmeg, points out that in the US bond sell-off only 13 per cent of trades of iShares iBoxx $ High Yield Corporate Bond ETF were redemptions - people wanting to sell out. That means that the majority of the trade was in the secondary market and did not require any buying or selling of the underlying bonds at all.
Third Avenue Focus Credit Fund was also not a normal bond fund. It invested in distressed debt issued by companies undergoing restructuring or negotiating bankruptcy, and had large holdings of debt that had not been rated by any credit rating agency. In other words, this was not a normal situation and it is not representative of the high-yield bond market as a whole. The highest-traded bond ETFs were also US-listed products, not ones listed in the UK.
But the December ETF sell-off that happened in the US does raise important questions for UK investors when it comes to investing in bond ETFs. Options available on the London Stock Exchange include iShares Euro High Yield Corporate Bond UCITS ETF (SHYG) and SPDR Barclays Euro High Yield Bond UCITS ETF (JNKE). Unlike equities, bonds are not liquid and buying and selling them can be tricky at short notice. Also, with interest rates rising, bond markets are increasingly tricky to predict and subject to highly volatile swings.
However, the European and UK corporate bond markets are very different to the US market. "We have long cautioned that the many structural changes to the bond ecosystem that have reduced liquidity should be high on investors' risk radars," says Mr Port. "That said, we do currently own a small allocation of European High Yield, which we continue to believe will benefit from ongoing quantitative easing, and the cyclical recovery we see taking place in Europe. The European market has a different structure to the US market, with much lower energy exposure - a sector feeling the pain at present - and higher average credit quality. While there will always be correlation between the US and European high-yield markets, we take a medium-term view and believe that by holding through the volatility we will be well positioned to benefit from the underlying credit exposure."
A number of analysts are feeling cautiously - and selectively - positive about high-yield in Europe and the UK, which they argue is an area for value investors. "High-yield is attractive having had a difficult few months," says Adrian Lowcock, head of investing at AXA Wealth. "These bonds are less sensitive to interest rates and we focus on good quality bonds with short maturities, avoiding the energy sector."
Mr Port adds: "Rising rates are not necessarily a bad thing for investors in high yield. The big risk for the asset class is that investors begin to shift significant volumes of money out of high yield, and who is the natural buyer for these bonds? Firstly, this is an asset-class-wide issue, whether you are invested in ETFs, mutual funds or direct bonds. Secondly, investors' search for yield has not disappeared overnight. One of the reasons the asset class has seen so much attention from investors over the past three years is the need to generate returns in an environment where return expectations have come down across asset classes, and this is still the case."
