HYG's Big Day: An ETF Liquidity Case Study

| About: iShares iBoxx (HYG)

High-yield bonds have been getting a lot of attention lately. Between historically low yields and record high prices, these "junk" bonds are looking less junky by the minute. But while some investors don't feel the reward is worth the risk, others (including Russ Koesterich) believe there are still some compelling reasons to hold high yield.

It was against this backdrop that on Tuesday, June 4, the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG) -- the largest ETF in its category (as of June 11, 2013) -- experienced its biggest trading day ever. In the course of one session, the fund saw $1.32 billion in trading volume, surpassing the $1 billion mark for only the second time (the first time was the previous Thursday, with $1.032 billion). And while on the balance there were more sellers than buyers and the fund did see $210 million in redemptions, there was still plenty of two-way activity. Let's dig into the numbers to see what we can learn:

  • On average, the entire U.S. fixed-income ETF market experiences about 5x as much secondary market trading (e.g., on the exchange) as they do primary market trading (e.g., creations and redemptions). In other words, for every $5 of fixed-income ETFs traded on the exchange, there is $1 of corresponding bond trading. The $1 in bond trading represents the excess supply or demand in the market -- meaning that in periods of excess supply, shares of bond ETFs are being redeemed, and in periods of excess demand, new shares of bond ETFs are being created.
  • HYG, on the other hand, experiences on average about 10x as much secondary market trading volume as primary bond market volume -- one of the benefits of being the biggest fund on the block. Stated another way, creations and redemptions for HYG are relatively infrequent because there's so much volume on the exchange.
  • When trading in HYG spiked Tuesday, the fund's ratio of exchange to bond trading condensed from 10:1 to 5:1. In other words, even with the increased selling pressure, the fund still experienced the average secondary-to-primary ratio for the fixed income ETF category.

One important thing to note is that amid all this volume, HYG closed at an 81-basis-point discount to its net asset value (NAV). The difference is caused by the fact that most high-yield bonds do not trade every day, and benchmark values (and most NAV calculations) are generally calculated based on estimates of individual bond prices. In fact, in high yield less than 10% of the bonds trade each day, which means that over 90% of the market is valued using estimates. These estimates incorporate the best available information, but still tend to lag in fast moving markets. In these markets we can see that HYG's price leads its NAV and market indices, which take a few days to catch up. This is one of the reasons why ETFs like HYG have become an important vehicle through which investors manage their high-yield exposure -- because they are a real-time access vehicle that reflects current market sentiment.

So what does all this mean and -- perhaps more importantly -- why should investors care? What I find most interesting about this case study is how nicely it illustrates the power of secondary market trading volume in ETFs. HYG has created additional liquidity for the market, essentially turning $210 million of bond trades into $1.3 billion of high-yield activity, bringing together a broad range of investor types who can all access the liquidity. And that should be good news for even the most conflicted investor.

Source: Bloomberg, TRACE, BlackRock.

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Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.