Have you heard the myth that high yield ETFs are exacerbating market sell-offs? Yup, me too—far too many times. This blame game, repeated after almost every substantial market stumble, typically centers on the thesis that high yield ETFs are creating a systemic threat to the bond market by providing liquidity to an illiquid market. Another common complaint is that they dominate trading volumes and are unduly pushing around the underlying high yield market.
Let me set the record straight: this myth is misguided. High yield ETFs represent a small portion of trading volumes and assets, and as I will discuss here, they have been shown to have little impact on underlying individual bond prices. Instead, time and again, high yield ETFs function as intended in periods of market stress, offering liquidity and price transparency to an entire asset class in a single, efficient vehicle.
In this two-part series, I want to debunk the myth that high yield ETFs are a hazard to the broader market, and I hope these blogs can serve as reference points the next time market flares put high yield ETFs under the glare.
Evaluating high yield ETF’s impact: Be sure to hit the right volume button
High yield ETFs are uniquely structured to offer two levels of liquidity—primary market liquidity and secondary market liquidity. But confusion about this liquidity and resulting trading volumes can spark accusations that high yield ETFs are influencing the price of underlying high yield bonds.
For a refresher, primary market activity refers to the creation and redemption of ETF shares. Trading on the secondary market entails the buying and selling of existing ETF shares. Secondary market transactions do not always result in the creation or redemption of ETF shares. In fact, the ratio of secondary to primary activity for the entire high yield ETF industry—as defined by Bloomberg Finance L.P.—is 5:1.1 This means that for every $5 traded on the secondary market, only $1 is created or redeemed.
When myths about high yield ETFs arise, this ratio is the single greatest retort to the claim that it is hazardous to provide liquidity to an illiquid asset class. It clearly illustrates that only a fraction of all high-yield ETF trades touch the asset class. Meanwhile, as a result of the liquidity provided by the secondary market, investors can transfer risk, modulate exposure, and tailor portfolios with precision and efficiency using just one vehicle—an ETF.
A deeper dive into the primary market
As the example above shows, comparing secondary market high yield trading volume to underlying high yield single cash bond trading volume is not an accurate method to gauge the impact of ETFs. Instead, to decipher the effect that high yield ETFs have on the underlying cash bond market, you need to study primary market notional activity, which leads to the purchase or sale of individual high yield bonds. So, what does this entire high yield picture look like?
The chart below puts high yield trading volumes in perspective. Over the last year, the total trading of high yield single CUSIP bonds—or individual securities—has averaged $11 billion a day.2 Secondary market ETF volume stands at $2.3 billion; however, remember this figure reflects transactions between two parties of already created ETF shares.3 When it comes to the average daily notional activity that impacts underlying bond prices—the primary market ETF creation or redemption activity—the number stands at just $418 million.4