Redemption And Reality In High-Yield ETFs

May.24.12 | About: iShares iBoxx (HYG)

The high yield bond market is back in the news again. On the back of increased concerns over the events in Europe there has been an increase in high yield market volatility over the past few weeks. Investors have seen this in the price movements of HYG, the iShares iBoxx High Yield Bond ETF. Of particular focus has been a series of redemptions out of HYG and other high yield ETFs. These trades have been at times misunderstood by market participants, so I’m going to try to provide some clarity.

First off, it’s important to remember that HYG, just like all other iShares ETFs, has a process by which shares can be created and redeemed in large quantities on a daily basis (see a video explaining this concept here). So if investors are leaving the high yield bond market and selling shares of HYG, this may result in shares of HYG being redeemed and the shares outstanding declining. This is a classic example of the ETF creation/redemption process in play.

But what’s interesting about the recent activity is that in addition to investors exiting the high yield market, some of the redemption activity we have seen in high yield ETFs is from investors who actually want to own high yield bonds. Confusing? I’ll explain.

Let’s say that you are a large investor and you want to build a high yield bond portfolio. You know that transaction costs in the high yield market can be very high and that, due to the nature of the over-the-counter bond market, it could take days or even weeks to build a diversified portfolio. With the growth of high yield ETFs, you now have a faster, cheaper way of building a bond portfolio – by buying shares of the ETF on the exchange, and then redeeming those shares in exchange for bonds from the ETF.

This is what happened with some of the redemptions we recently saw in the market. Large investors wanted to own a diversified portfolio of high yield bonds, so they bought up shares of a high yield ETF on the exchange, and then redeemed the shares of the ETF for the underlying bonds. This is exactly what HYG and our other high yield iShares ETFs are designed to do – provide a liquid alternative to the over-the-counter bond market.

The key to such a trade is that HYG and our other fixed income iShares ETFs primarily use an “in kind” creation and redemption process, which ensures that the costs of creating and redeeming shares are kept outside the fund. The transaction costs for creations and redemptions are borne by the transacting investor, and don’t impact other shareholders.

Investors should note that not all fixed income ETFs use the same creation and redemption mechanism employed by HYG. I would recommend that investors do their due diligence on any ETF that they are looking to invest in to ensure they understand the details.

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