Posted inFixed Income

High yield bond ETFs more safety valve than agent of instability – Morningstar

High yield bond ETFs have grown significantly in the past decade from a standing start to now accounting for over $51bn. And, their high visibility within a market into which many investors have been forced by low returns and the hunt for yield means questions are increasingly being raised about how they will react should liquidity dry up.

In a new report titled:  High-Yield Bond ETFs – A Primer on Liquidity, senior ETF analyst Jose Garcia-Zarate looks at the increasingly important role being played within the high-yield market by ETFs and argues: “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.”

Zarate’s conclusion is based on an analysis of the difference between the primary and secondary markets layers of liquidity within ETFs markets, a distinction crucial in understanding how ETFs actually trade. “One of the most common misconceptions when it comes to ETFs and liquidity is that every purchase or sale of an ETF share necessarily has an impact on the underlying market,” he says.

While acknowledging that ETFs can never be more liquid than the underlying market they track, he points out that investors in ETFs also operate in the secondary market, buying and selling existing ETF shares like common stock by means of traditional market-making channels, which adds an extra layer of liquidity. And, it is only when there is a supply/demand imbalance within the secondary markets that ETF providers have to create or redeem units.

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