Fixed Income  

Morningstar on high-yield ETFs instability concerns

Morningstar on high-yield ETFs instability concerns

Morningstar has moved to dismiss fears high-yield bond exchange-traded funds (ETFs) act as “agents of instability” in times of stress, with the firm claiming they in fact ease pressure in markets.

In its research paper, ‘High-yield bond ETFs: A primer on liquidity’, the ratings agency noted demand for, and high usage of, the products meant they had caught the attention of regulators.

According to Morningstar data, global assets under management in high-yield bond ETFs have grown from zero in early 2007 to $51bn (£35bn) by mid-May 2016.

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However, senior ETF analyst Jose Garcia-Zarate argued concerns about the ability of the products to operate in stress scenarios predominantly stem from “a lack of understanding of the on-exchange trading framework” used.

He said the notion that each sale or purchase of an ETF share meant an impact on the underlying high-yield market was incorrect.

While he admitted the ETF could never be more liquid than the underlying market, he said the virtue of the product meant it brought an “extra layer” of liquidity.

“Far from being agents of instability, high-yield bond ETFs have acted as a safety valve in a marketplace where, largely because of post-crisis banking regulation, the availability of ready-to-trade fixed income inventory has been on a declining trend,” Mr Garcia-Zarate said.

“Investors operate in the secondary market, buying and selling existing ETF shares like common stock. This is the extra layer of liquidity ETFs bring about, and it can be extremely useful in the case of fixed income exposures.”

He said the bulk of operations in times of stress were “netted off” between buyers and sellers of existing ETF shares.

Morningstar analysed the three largest European-domiciled high-yield bond ETFs – which account for 75 per cent of assets and 80 per cent of trading. The firm said all three products showed healthy secondary/primary market activity ratios.

Mr Garcia-Zarate used the research note to suggest industry and regulatory concerns about high-yield bond ETFs stemmed from concerns on the asset class itself, not the product.

“The very dynamic secondary market trading of high-yield bond ETFs has allowed investors to express investment views about the asset class without unduly affecting the liquidity of the underlying market,” he added.

But he said if liquidity dried up in high yield as a whole, it would naturally affect all investors.

“Faced with the ultimate worst-case scenario where there are only sellers and no buyers, an ETF shareholder intent on liquidating a position should be able to transact, even if at very unfavourable prices. This affords ETF holders an ‘escape route’ that would not be available to investors in traditional high-yield bond mutual funds,” Mr Garcia-Zarate explained.