- The High Yield Debt ETF market may not be what it appears to be.
- Liquidity and market mechanics in HY need to be considered.
- The impact of outflows and a turn in the credit cycle could cause unexpected results.
High Yield ETFs: Beware
In this article I hope to shed light on factors concerning the high yield market and, more specifically, the ETF industry's role in this market. My thesis centers on the idea that the mechanics of the high yield credit market are being overlooked by ETF investors. Moreover, some key assumptions could be questioned in a time of high market outflows or a turn in the credit cycle.
In the past few weeks the high yield market has seen record outflows. Part of this can be explained by the fact that the market is bigger than it has ever been (and on that note more mature than ever before). Strategically, outflows aren't shocking to any market participants given the current rate environment. More importantly, with the current spread on the high yield index it seems logical that ETF investors might be thinking about putting their money elsewhere. But as that story unfolds lets consider the mechanics of ETF selling and how that could impact future investment.
Why Are High Yield ETF's attractive?
Proponents of the high yield ETF have a few typical points: 1) easy exposure to the HY market, 2) diversification within the market itself and 3) the attractive pricing of passive management just like any other ETF. I'm sure I could go on, but I thought it would be good just to touch on the basics. The key takeaway here is that the ETF, as in many asset classes, is attractive because it allows exposure to a market the investor probably doesn't have as deep of an understanding of as large cap stocks; the valuation process is different, the legal element of covenants can be intimidating, the access to individual bonds is nearly inexistent, there are multiple credit ratings within high yield, and the contingencies attached to various tranches of debt vary greatly. So the logic is: "why not get broad, cheap, index exposure with all of this foreign, inaccessible complexity?"
The Other Option:
The logic above may seem to hold up, but I would challenge you to think a little harder about this. With everything explained above, it might not be such a bad idea gain exposure through an active manager whose sole responsibility is monitoring this- relatively foreign - market. Granted, most active managers are focused on institutional clients, but their expertise in this asset class is the other solution to investing in HY debt. In a market marked by numerous securities within each company, all containing extensive contingencies (i.e. equity claws, restricted payments tests, callability) it isn't a bad idea to have dedicated pros looking out for you on a daily basis. So for the typical retail investor this is different than equities: you don't get to be a stock picker (or at least probably shouldn't). Your choice is broad index exposure or the pricier alternative of active management.
The Issue of Market Mechanics:
I thought this would be an effective and simple explanation of some background info before I point out the problem I see:
"Because ETF shares are freely exchangeable for the assets that make up the ETF, the value of the shares never deviates very far from the value of the assets, known as net asset value (NAV). If the shares increase in value, authorized participants can trade in assets for more creation units to sell on the market. This creates an increased supply of the shares, which pushes the price back down. If the opposite occurs and the ETF's shares are trading for a value less than the NAV, the shares can be traded back to the ETF in exchange for the assets themselves. This makes it almost impossible for the ETF shares' value to drop too far below the assets' value, since investors can always just trade the shares for the actual assets."
That last line is key. In high yield debt this is simply not the case. In times like these, where the market is being stress tested with outflows, liquidity becomes a real concern for everyone, including ETF's. Due to Basel III and Volcker bond inventory at every dealer has been severely cut. As a result, an ETF's ability to trade its underlying security could become impaired, resulting in a considerable separation from NAV.
I realize that this hasn't been the most thorough walkthrough of ETF or high yield mechanics, and I welcome the discussion that this brings. However, investors who like ETFs for their similarity to open-ended funds' NAV-matching characteristic should consider the dynamics of the high yield market before investing. As is the case in so many instances in investing, it is pertinent to consider the underlying assumptions.