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Questions are being raised about high-yield bond ETFs, which have seen record daily trading volumes during recent weeks.

Frank Harms

Legendary corporate raider Carl Icahn warned that trouble was brewing in the fast-growing exchange-traded fund (ETF) industry when he locked horns with BlackRock Inc. chief executive officer Larry Fink in 2015.

The world’s largest asset manager had created an illusion of liquidity in high-yield bond ETFs that would lead to a destructive “blow up” for investors, the billionaire claimed.

“We are riding for a fall. There is definitely a great risk [in high-yield ETFs],” Mr. Icahn said.

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For now, such gloomy predictions appear to have been confounded by the performance of the vast bulk of ETFs during the turmoil that has convulsed markets because of the coronavirus pandemic and looming global recession.

But questions are being raised about high-yield bond ETFs, which have seen record daily trading volumes during recent weeks.

BlackRock’s iShares iBoxx $ High Yield Corporate Bond ETF (HYG-A) and its most direct competitor, State Street Global Advisors Funds Distributors LLC’s SPDR Bloomberg Barclays High Yield Bond ETF (JNK-A), have both suffered large asset declines this month.

High-yield bond ETFs have seen acute selling pressure. Many are exposed to U.S. energy companies that could be forced to default on debt payments because of the sharp fall in oil prices following Saudi Arabia’s decision to declare a price war with other crude producers.

Global assets held by ETFs have doubled in size in less than four years, reaching a US$6.4-trillion record at the end of 2019. This explosive growth has attracted scrutiny by regulators who are concerned about the influence of ETFs as they spread deeper and wider into financial markets worldwide. Regulators worry that ETFs could intensify market turmoil if their investors herd together in a charge for the exit.

Both HYG and JNK have traded at significant discounts to their underlying indexes this month. Such discounts add to concerns over whether investors are receiving a fair deal when they come to sell these ETFs.

Marcus Miholich, head of the ETF capital markets group in Europe at State Street Global Advisors, says it is not unusual for high-yield bond ETFs to trade at a discount in periods of elevated market stress.

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“It is unfair to say there is a dislocation between the ETFs and the high-yield market. High-yield ETFs are more liquid and easier to trade than the basket of underlying bonds. Some of these bonds do not trade very much so their prices are stale because the market is moving so quickly. The ETF functions as the price discovery vehicle because this is where investors choose to transact,” Mr. Miholich says.

Samara Cohen, co-head of iShares markets and investments at BlackRock, says there was no evidence that increased trading activity in HYG was causing forced selling of the underlying high-yield bonds.

“The ETF is the vehicle that investors choose to manage their risks and to allocate capital efficiently. Investors make thousands of times more trades in the ETF than through the underlying bonds,” Ms. . Cohen says.

Jane Street Group LLC, one of the largest ETF market makers, says elevated trading volumes indicated that investors were looking to high-yield ETFs to shift their credit risk because of increased liquidity challenges in the cash bond market.

“High-yield ETFs have continued to function at high volumes in stressed markets, supporting price discovery and risk transfer, even if it may not be at a price investors are seeking,” says Jane Street.

Pricing dislocations have also appeared in BlackRock and Vanguard’s flagship fixed income ETFs as a result of the volatile conditions across the U.S. fixed bond market.

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Vanguard Group’s US$55-billion Vanguard Total Bond Market ETF (BND-Q) closed at a 6.2 per cent discount on March 12. The US$71-billion iShares Core U.S. Aggregate Bond ETF (AGG-A), closed at a 4.43 per cent discount on the same day. BlackRock and Vanguard both insist that these ETFs, with their increased trading volumes, are providing the most accurate and timely barometer of bond market conditions.

ETFs regularly account for a quarter of daily trading activity on the U.S. stock market and this has risen to about 40 per cent on some of the most volatile days on Wall Street over recent weeks.

“ETF usage increases when volatility goes up. ETF trading also increases when market liquidity goes down,” says Ms. Cohen.

Ensuring that ETF trading remains orderly is therefore of critical importance to the overall stability of the U.S. stock market.

“There has been extraordinary market volatility and we haven’t seen any major problems with ETFs. They have continued to function as normal. If there continues to be no major issues, this should help allay some of the concerns among policy-makers about any potential risk of ETFs,” says Sean Tuffy, a regulatory expert at Citi.

Circuit breakers – temporary halts to trading – have been imposed a number of times this month to calm violent falls in the U.S. stock market. Temporary halts to trading have caused problems for ETFs in the past. More than a fifth of all U.S.-listed ETFs were forced to stop trading on a tumultuous day in August 2016 after the Dow Jones Industrial Average dropped almost 1,100 points shortly after opening and then rebounded by almost 600 points minutes later.

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But no similar problemshave emerged in the latest bout of market turbulence, due in part to a tightening of trading rules.

“Rule changes after 2016 have improved market stability. ETFs have behaved in an orderly fashion during this latest period of extreme market stress,” says Ms. Cohen.

The S&P 500 has fallen more than 25 per cent from its all-time high in February, marking an end to its 11-year bull market run. During this period, the largest ETF tracking the S&P 500, SPDR S&P 500 ETF Trust (SPY-A), has registered trades worth more than US$50-billion for 14 consecutive days. SPY dealing volumes reached US$113-billion on Feb. 28, a record for any trading instrument.

Mr. Miholich says that SPY has even been able to function as a price discovery vehicle during temporary halts to U.S. trading. This is because the SPY ETFs, which are listed in Europe, were unaffected by the U.S. circuit breakers and continued to trade.

The vast majority of ETF trading occurs in the first and last hour of each trading day.

This means the liquidity provided by ETFs “may not be stable” over time, cautions Sébastien Lemaire, head of ETF research at Société Générale S.A.

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If there’s insufficient intraday liquidity provided by the ETF market, investors might be forced to redeem their ETF shares to complete a trade using the underlying constituents, which could be a less efficient and more expensive process.

“ETF liquidity is not infinite, and its cost and quantity are impacted by severe market conditions, just the same as any other security,” says Mr. Lemaire.

Hector McNeil, co-founder of HANetf, a fund incubator, also cautions that ETFs could not create liquidity “by magic” if the underlying market was struggling.

“ETFs are not Harry Potter products. They can’t create magical liquidity,” he says. “If the underlying asset is suffering this will be reflected in the volatility of the ETF.”

© The Financial Times Limited 2020. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied or modified in any way.

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