Change is often said to be good. But it is rarely easy. No wonder, then, that some veterans in the junk bond market have bristled at the rising prominence of exchange traded funds in recent years. Assets under management in U.S. junk bond ETFs have grown from $300-million in 2007 to $32-billion now, according to Lipper. The two biggest funds – ticker symbols HYG and JNK – run by iShares and State Street respectively, account for nearly all of that. This is still small compared to the money that has been amassed in junk bond mutual funds – more than $250-billion – but it is enough to get noticed.
The rise of ETFs in junk bond land is, in part, a function of the rise in demand for junk bonds themselves. Since the financial crisis, investors have poured money into assets with the highest yields as central bankers kept official rates near zero. Junk bonds have been a big beneficiary, returning an annualised 22 per cent since the end of 2008, according to a Barclays index. But ETFs are also growing in popularity in the junk bond market for the same reasons investors like them elsewhere: fees are low and the liquidity is high.
Concern has emerged that junk bonds and ETFs are not the right match, however. ETFs can work in a big liquid market like equities, the naysayers say, but they risk distorting prices in the illiquid over-the-counter arena where junk bonds trade. How? ETFs concentrate trading in the group of companies in the indices which they reference, heightening volatility as investors trade in and out of the ETFs and bonds are sold or bought to create or redeem the ETF shares. Fans of ETFs counter that they don't create the volatility, but just reflect it a way that was never possible before. Since ETFs were still nascent in 2008, they have yet to be tested in a bear market. That is when we will really know if this change is, indeed, a good one.