Investors have started abandoning the U.S. junk bond market — or at least the ETFs that track it.
BlackRock's iShares iBoxx High-Yield Corporate Bond ETF (HYG), the biggest ETF focused on speculative-grade debt, suffered $1.5 billion of outflows in May, the most in a year. Short-interest also rose last month to the highest this year amid fresh political upheaval from the U.S. to Brazil and rekindled concern over tight valuations and the pace of reflation.
The second biggest junk bond ETF — State Street's SPDR Bloomberg Barclays High-Yield Bond ETF (JNK) — also suffered $424 million in outflows in May, for a three-month total of $1.4 billion, as short interest hit a high for the year.
With the riskiest corporate debt more widely held — the U.S. high-yield market has more than doubled to $2 trillion since 2010 amid a boom in ETFs and other passive investment products — these funds serve as useful signals of coming market turbulence. After all, their $29 billion in combined assets accounts for roughly a third of the cash in global junk bond ETFs.
Still, it's worth noting that the largest European high-yield ETF, the $5.6 billion iShares Euro High-Yield Corporate Bond UCITS ETF (IHYG) had inflows of nearly $198 million in May.
The outflows from U.S. funds have rekindled a popular concern that they could portend the start of a liquidity crunch if more trouble emerges.
"The biggest unknowable is that you have the delusion of liquidity," Mohamed El-Erian, Allianz's chief economic adviser, said in an interview. "You have people who promise overnight liquidity that have taken quite illiquid positions, particularly lending to various entities. As long as the party continues that's fine, but should this liquidity be tested it's not going to be as deep as people think."
So far, though, these worries appear to be overblown. Measures of liquidity show investors have less to fret about than in 2009, when the financial crisis all but froze trading in riskier assets. Bid-ask spreads, the difference between how much it costs to buy and sell junk bonds in the U.S., are about a third of what they were then, according to IHS Markit.
A lot has changed since then, particularly the rise of passive investing in the high-yield market through ETFs. But here, too, there's evidence that liquidity can remain robust. A week before the U.S. election, HYG was hit with a single-day outflow of $1 billion — yet the fund barely lagged wider index returns. That underscores how ETFs can trade very close to their net asset value even in tumult, according to Simon Colvin, analyst at IHS Markit.
"When you get outflows, investors who also track the same index or asset class may be ready to jump in," he said.
Even small ETFs have mechanisms that help them cope with sudden outflows. Using in-kind payments they can swap a basket of securities from their underlying benchmark index for shares, shifting the cost of redemptions to the redeeming shareholders.
How well ETFs can function in stressed markets is a question that's been ruminated over by regulators from the Financial Stability Board to Ireland's central bank, which sought greater transparency in a report last month.
The surging popularity of ETFs ultimately could put them at the center of a market disruption, according to market strategist Bill Blain of Mint Partners, a global brokerage firm in London.
"The liquidity implications of the amount of cash tied up in ETFs are dimly understood," Blain said. "The amount of passive money is scary. Folks might just want it back sometime."