Exchange-traded funds (ETFs), which originated primarily as investment products for equity investors, have become more prominent within US fixed income markets, particularly corporates, according to Fitch Ratings.
In its report, entitled
‘Bond ETFs: Rising Influence on High-Yield Markets’
, the credit ratings agency (CRA) says that their relevance has increased with the reductions in dealer inventories of corporate bonds, as new US and global financial regulations have increased capital and liquidity requirements on banks’ trading activities.
For example, the five largest investment-grade corporate bond ETFs total about US$46bn in assets as of end-June 2013, compared with dealer inventories of about US$9bn. For high-yield corporate bonds, ETF assets are about US$28bn, roughly four times the US$7bn in dealer inventories.
Fitch comments that although US corporate bond ETF assets total less than 2% of the US corporate bond market (which the Securities Industry and Financial Markets Association [SIFMA] estimates at about US$9.2 trillion as of end-March 2013), their influence on trading activity is relatively more significant, particularly for the high-yield sector.
Average daily trading volumes, on a weekly basis, for the five largest high-yield corporate bond ETFs more than tripled from about US$470m in early May to more than US$1.5bn in early June. This ramp-up in trading activity points to the utility of ETFs in allowing investors to rapidly enter and exit fixed income positions during a period of market turbulence.
However, the CRA suggests that increased ETF trading volumes might also amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds. For context, recent Federal Reserve Bank of New York research indicates that an investor or dealer liquidation of more than US$250m in corporate bonds in one day could begin to adversely affect bond prices.
The rising popularity and influence of corporate bond ETFs indicate the increasing importance of market liquidity to many fixed income investors, Fitch concludes. This investor appetite for liquidity might partly explain why ETFs comprise a relatively higher proportion of trading in high-yield corporates versus in investment-grade bonds.
ETFs provide a mechanism for fixed income investors to trade more actively within the high-yield market, helping to compensate for the relatively lower liquidity in the underlying bond market. An interesting question going forward is whether issuers and underwriters respond by taking steps to enhance the liquidity of corporate bonds.
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