Speculative-grade, high-yield, junk bonds have experienced heavy selling over July.
Hedge fund bets may have contributed to the wild swings.
Investment-grade corporate debt may be a more stable play.
The notoriously illiquid junk bond market has experienced wide short-term swings as hedge funds execute broad bets with high-yield bond exchange traded funds.
According to J.P. Morgan, hedge funds account for 30% of holdings of junk bond ETFs and have contributed to the recent swings in the ETFs as fast-money quickly exited and re-entered the market, Business Recorder reports.
"The ETFs in high yield have a much greater impact on that asset class than the investment-grade ETFs have on the high-grade bond market," Oleg Melentyev, head of credit strategy at Deutsche Bank, said in the article.
As hedge funds dumped ETFs in early July, the junk-bond cash market was inundated with a huge list of bonds that funds wanted to sell in order to keep up with ETF redemptions. However, there are not enough buyers in the illiquid market to keep up with the sell side. Consequently, selling pressure escalated, further exacerbating volatility and bid-ask spreads.
In comparison, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD) was only down 0.3% over the same period.
"That's because the high-grade market is so much bigger versus the size of the ETFs," Melentyev added. "Investment-grade ETFs have US $17bn of assets, and high- yield about US $12.5bn, and the underlying IG market is about three to four times larger than the high-yield bond market."
Due to the forced bond selling by ETFs to meet the surge in redemptions, a number of institutional fund managers have been able to jump in after the excessive sell-off, turning sudden moments of illiquidity into opportunities for generating outperformance.
"You can make a lot of money from buying things when ETFs blindly sell them, and you have seen increasing numbers of portfolio managers doing this," Ashish Shah, head of global credit investment at AllianceBernstein, said in the article. "That's the reason why the high-yield market has come back so quickly."
Consequently, market observers argue that we will likely experience increased bouts of volatility ahead as more investors try to capitalize on selling pressure in an illiquid market.
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own shares of JNK, HYG and LQD.