Ok, guess what?
It's time to start talking about the next risk factor for ETPs. Monday proved beyond a shadow of a doubt that structural issues in exchange-traded products can manifest themselves in dramatic fashion. Monday also proved - again, beyond a shadow of a doubt - that the worst case scenario for ETPs can indeed materialize under the "right" conditions.
I realize this is a painful and contentious subject. There are two (related) reasons why it's so painful and contentious:
- ETPs represent the democratization of markets and thus are generally seen as a giant leap in the direction of giving retail investors the opportunity to exercise their own judgement on asset allocation without interference from professionals who charge exorbitant fees.
- It's generally assumed that this democratization is a good thing.
I have variously argued that the democratization of markets has gone too far in the post-crisis years. I contend that the active-to-passive shift is embedding a lot of systemic risk and part and parcel of that is the proliferation of exchange-traded products that allow retail investors to access corners of the market they normally wouldn't be able to access.
To be sure, short vol. and levered VIX ETPs bear no resemblance to SPDR S&P 500 Trust ETF (SPY) in terms of the risk involved. So do me a favor and don't construct a straw man argument by accusing me of equating the two.
But what's critical to understand is that there is a continuum here where SPY is on one end and XIV on the other. In fact, in the wake of Monday's dramatic unwind in the short vol. ETPs, Bloomberg installed a new feature that actually tries to tell you where ETPs fall on the risk spectrum in order to (and this is a direct quote from Bloomberg) "save you from yourself." Here's a screengrab:
Bloomberg isn't the only one trying to save you from yourself. On Friday, Fidelity revealed that they are (at least temporarily) banning retail investors from trading short vol. ETPs.
The bottom line here is that retail investors should not be allowed to access certain corners of the market and to the extent that was a statement that was somewhat taboo last year, you can go ahead and count Fidelity - one of the largest retail brokerages in the country - among those who basically agree with me, at least as it applies to some of the short vol. products.
Well, if you look at that Bloomberg screengrab, you'll note that SPDR Bloomberg Barclays High Yield Bond ETF (JNK) gets a "yellow light", a distinction Bloomberg justifies with this: "less liquid holdings."
Regular Heisenberg readers know this is a favorite subject of mine and it was one of the things I wrote about most on this platform in 2016 and 2017, starting with the classic "Heisenberg's Labradors" posts (here and here).
The problem with these high yield ETFs is that the model flies in the face of common sense. JNK and iShares iBoxx $ High Yield Corporate Bond ETF (HYG) promise something that isn't possible in a pinch: intraday liquidity against an underlying basket of less liquid assets.
I'm not going to sit here and try to paraphrase myself or Barclays for the hundredth time on this. At a certain point, paraphrasing yourself and/or finding new ways to paraphrase someone else is insulting to readers because it imagines they don't remember the last time you said it and thus need to have it reiterated to them. Rather than do that, I'll just excerpt a passage from my latest junk bond ETF post and then excerpt the most cogent explanation of why the mechanics behind these funds might be a problem as spelled out in a seminal 2015 note by Barclays.
Ok, so here's the gist of it from a January post of mine:
I literally ran out of ways to communicate the HY ETF problem and that's saying something because outside of that subject, I have never exhausted my capacity to explain something in a different way than I've explained it before. To me, the most amusing thing about the liquidity mismatch issue is that it's one of those rare cases where constructive criticism is not welcome because there's nothing to criticize. Normally, I'm open to this refrain: "I don't have to agree with Heisenberg to enjoy his posts." When it comes to that HY ETF problem, that's not good enough. That is, "yes, yes you do have to agree with Heisenberg because there's nothing to not agree with." That liquidity mismatch is literally built into the structure of those things. It's not a matter of whether there is a liquidity mismatch, it's just a matter of whether you think it's a problem. You can argue the latter point, but not the former.
And here is Barclays' classic explainer which will one day go down as the definitive piece of work on these products (please do me a favor and excuse the lengthy block quote - this is a case where it is both desirable and highly necessary):
Are ETFs good or bad for corporate bond liquidity? In our view, the answer depends on the correlation of flows at the individual fund level. Although fund flows have been a major focus of market participants over the past several years, the aggregate flows attract the most attention. This is particularly true in the high yield market, where retail ownership is relatively high and the price swings associated with contemporaneous fund flows have been well documented. Aggregate flows have effectively become a market signal.
However, fund managers actually have to manage their particular inflows and outflows, not the aggregate flows. From the perspective of an individual fund manager, the risk posed by fund flows and the strategies available to help mitigate that risk depend to a large extent on the correlation of flows across funds. If flows are highly correlated then the risk is relatively high. Funds will have a difficult time selling bonds when they experience an outflow, since other managers would similarly be selling. In this circumstance, managers have a relatively short list of strategies to deal with flows. They can keep increased cash on hand, or (less likely) they can hope that other non-retail buyers step into the market at a reasonable discount to market levels.
On the other hand, if flows are relatively uncorrelated they may, in principle, pose less of a risk - funds with outflows can sell to those with inflows. Funds can exchange bonds (or portfolio products, see below) with other funds, rather than draw down on or build cash. This process may be made more difficult by the decline in liquidity, but the price discount/premium faced by an individual fund with an inflow or outflow could, theoretically, be limited by the existence of investors looking to go in the opposite direction.
While diversifiable flows limit the risks to portfolio managers in principle, the reality of the high yield market is more complicated. Managers have specific views on tenor, callability, sectors, covenants, and, most importantly, individual credits, such that actually finding buyers for specific bonds can be quite difficult. In the pre-crisis period, dealers ran large inventories that effectively facilitated the netting of flows across funds (Figure 1). A fund with an outflow would sell bonds into the dealer community, and funds with outflows would buy bonds out of the dealer inventory. When inventory is large, the fact that the specific bonds bought and sold did not match was largely irrelevant. Funds with outflows could sell the bonds of their choice, and the funds with inflows could pick investments from the large variety of inventory held by dealers.
The matching problem has become more acute as dealer inventories have declined. Even if funds can net flows in principle, dealers are much less willing to warehouse bonds, and are much more likely to buy only when they believe they can quickly offload the risk. Under this scenario, the fact that flows can theoretically be netted is of little practical use to fund managers - actually netting individual bonds is extremely difficult, particularly in the short time frame required by funds offering daily liquidity to end investors. This is where portfolio products come in. Investors can use portfolio products to fund outflows/invest inflows immediately and execute the necessary single-name bond trades over time as liquidity in the underlying bond market allows (Figure 2). In this scenario, funds with inflows and outflows simply exchange portfolio products, sidestepping (the immediate need to trade single-name corporate bonds.
Do you see the problem in that arrangement? The issue here is that if fund flows become unidirectional (as opposed to diversifiable), it is possible that the underlying bonds will have to be sold.
There are myriad arguments about why this isn't a problem for the ETFs, but they all (basically) depend on the assumption that the mechanism behind the ETFs will continue to work and that the participants will be willing to engage in the arb "opportunity". That arb will amount to catching a falling knife if market conditions become acute enough and I am by no means confident it will work. Deregulation may mitigate this risk to a certain extent by making banks more willing to lend their balance sheet, but ultimately I think the underlying liquidity mismatch in HYG and JNK will one day manifest itself in a way that causes serious problems.
Another related issue here is the extent to which active fund managers may be using HYG as a cash substitute. Consider this bit from Bloomberg's Mitchell Martin writing last July:
Investors who eschew junk-bond ETFs for active management may be surprised to learn that they haven't left the passive market entirely behind: dozens of high-yield mutual funds are among the largest owners of iShares iBoxx $ High Yield Corporate Bond ETF, according to Eric Balchunas, the Bloomberg Intelligence exchange-traded funds analyst. The $19 billion ETF is typically used as a liquidity sleeve, allowing active managers to meet purchases and redemptions of mutual-fund shares without having to trade the picks in their portfolios. In this way, the funds can be more fully invested in bonds than they would if they had to keep cash on hand for such transactions. Managers typically allocated 1-5% of their assets to HYG for this purpose. Only about 20% of the bonds in the HYG portfolio trade every day, so even though the ETF is super liquid, its holdings are not, which could spell trouble in a market sell-off. Investor Carl Icahn warned in 2015 that the ETF could "blow up," but the fund, launched a decade ago, hasn't had any problems yet.
"Yet", being the key word there. For those unfamiliar, the reference to Carl Icahn refers to a classic exchange with Larry Fink that unfolded live on CNBC in 2015. You can watch it here.
I do not have an exact read on the extent to which active managers are still using HYG as a liquidity sleeve, but I do know that a fair number of funds are still reporting sizable allocations to HYG. And really, it doesn't matter for the purposes of this article. The fact that that was ever going on points to the self-referential nature of this whole setup.
If you're an active high yield fund manager and you're avoiding selling the underlying illiquid bonds in your portfolio by holding HYG as a cash substitute, you are effectively reinforcing the underlying problem. When everyone dodges the cash market for the underlying bonds, that market becomes even more illiquid than it was before. Admittedly, "illiquid" is an amorphous concept, but common sense dictates that if something isn't used, it falls into a state of disrepair and my read on everything above is that if flows become unidirectional, the active fund managers using the ETFs as a cash substitute would be trying to raise cash from selling those ETFs into a secondary market where everyone else is selling the ETFs too. The bids would dry up and eventually, somebody, somewhere would have to tap the underlying market for the relatively illiquid bonds. If there's a hint of fear in the air, the prices would fall there too because no one would want those bonds, and that would exacerbate the situation for the ETFs, and around we go. The only conceivable way out of that scenario (at least in my mind) is if ETF sponsors have continued to arrange for emergency credit lines like they reportedly began doing in 2015.
Again, most people will tell you that this isn't the way it would play out, but I've talked to dozens of people about this over the last three-ish years and I've yet to hear a convincing argument that doesn't effectively beg the question by leaning heavily on the assumption that the market will never stop functioning normally.
That's not to say there are not a ton of good arguments for why the above wouldn't ever happen, but remember, there were a ton of good arguments for why those short vol. ETPs wouldn't ultimately cause a 100% spike in the VIX. Sure, the arguments for why the high yield ETFs won't be a problem are infinitely better than the arguments people were making last year to support the notion that XIV and SVXY weren't dangerous. Additionally (so again, don't construct a straw man by putting words in my mouth), HYG and JNK are infinitely safer than the short vol. products that ran into trouble on Monday.
That said, HYG and JNK are not anywhere near as fool-proof as popular equity ETFs like SPY. And see that gets us back to the whole continuum thing. On one end are the safest ETFs (SPY being the gold standard there) and on the other end are the short vol. ETPs. The assumption is that HYG and JNK are only marginally closer to the middle of that risk continuum than SPY (you can see that visually in the Bloomberg screengrab above).
My argument is simply that the high yield ETFs belong somewhere in the middle as opposed to somewhere just left of SPY (if the far-left end of the continuum is "dangerous" and the far-right end is "completely safe").
I don't think that is an unreasonable argument to make given the concerns outlined above. In fact, I would go so far as to say it's the only rational way to think about this given the liquidity mismatch.
Ok, so here's the thing: if the equity rout continues, I think it's just a matter of time before all of the above gets subjected to a trial by fire. Outflows from HY vehicles are piling up as money flees equity funds. Here's BofAML:
Outflows from high yield have accelerated in response to the weak secondary environment, with retail funds and ETFs losing $2.4bn over the last week alone (-$1bn HY ETFs, -$1.4bn open-end). On a trailing 4 week basis, US HY funds have lost $5.6bn (- 2.4%), the most since March 2017.
As you're probably aware, JNK and HYG are looking extremely shaky against that backdrop. The two-week loss for HYG was the largest since early 2016 when crude prices were in a dive:
Have a look at spreads:
That's pretty dicey. Here's that chart with stocks:
Now consider this out from Bloomberg late in the trading week:
By Friday, more sales of underlying bonds were starting to populate the bond-price reporting system known as Trace:
- A $2.25 billion bond issued by energy explorer California Resources Corp. dropped almost 6 cents on the dollar the past two days to 78.25. That pushed the yield on the debt, rated in the lowest tier of speculative grade, to over 14 percent.
- Frontier’s $2.18 billion of notes due in 2022 have fallen more than 5 cents this week to 79, with the yield rising to more than 17 percent.
- Community Health’s $3 billion of debt due in 2022 tumbled to 63.875 on Friday from 71 at the start of February, pushing the yield to 21 percent.
That looks like the first sign of trouble to me.
To be fair, absent a change the environment for defaults (i.e., signs that the cycle is definitively turning), there's not a particularly compelling reason to make a dire prediction. That is, there's not a fundamental case as of yet. Underscoring that is Margaret Patel, a senior portfolio manager at Wells Capital Management who told Bloomberg this:
People are expecting this to bleed over into high yield. Well, how much can you push with low defaults and people wanting yield?
That's a good point. But again, I think the setup here is the issue. Just as VIX ETPs made the VIX futures market more vulnerable than it would have been otherwise, I think the high yield ETFs are making the junk market more prone to problems than it would be in the absence of those products.
Ultimately, my message to investors in those ETFs is the same as it's ever been. That is, make sure you understand what you own and make sure you understand the liquidity mismatch.
You can argue that the liquidity mismatch is not a problem, but you can't argue that it doesn't exist.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.