High Yield Junk Bond ETFs-Eye On Distortions

It appears that our comments re:  junk bond ETFs over the past 6 weeks has inspired main stream media, and in particular, WSJ’s Jason Zweig, to zero in on a talking point raised here last month: the logistics by which certain ETFs are ‘created’ and redeemed, and the potential distortion in prices between the underlying junk held by high yield bond ETFs, and comparable  junk issues that are not components to the most popular high yield bond ETFs.

According to weekend’s Wall St. Journal column by Zweig, “several industry analysts suggest the boom in junk bond ETFs is creating two distinct classes of bonds–one of which might be riskier than the other..”

Without our taking on the risk of a plagiarism charge, the “Cliffsnotes version” of Zweig’s article, which is one that takes a circuitous path to an even more important point, is that buyers of popular junk bond ETFs typically pay a premium (vs. the underlying components) when money is flowing in, and find themselves selling at a discount when there are more sellers than buyers.

This nuance is not really news to anyone that trades anything, whether ETFs, high yield bond ETFs, or any other product.  Adding a further grain of salt, Zweig suggests that high yield bond ETF buyers and sellers are subject to a potential “premium on a premium” paid by investors when taking into account the distortions that result from large inflows and outflows.

“Good points, but not that simple,” says ETF market expert Chris Hempstead. “The largest high yield bond ETF issuers typically maintain a big warehouse of underlying components; when new money flows into the specific fund (e.g.”HYD” or “JNK”), the issuer doesn’t necessarily have to go to the high yield bond market to ‘create’, as they already have the ‘parts’ in inventory.”

Added Hempstead, “Conversely, if significant outflows occur, it shouldn’t be surprising if the cash ETF might temporarily trade at a discount, simply because the underlying components would be subject to some selling pressure. Whether trading names such as HYD, JNK, or less-appreciated issues such as PHB or SJNK, the take-away is that managers or investors need to make sure they are executing through a desk that has their fingers on the pulse of the underlying issues, not merely the cash ETF.” Read the full article here: