Obtain free Investing in funds updates
We’ll ship you a myFT Every day Digest e mail rounding up the most recent Investing in funds information each morning.
Lots of people viscerally hate the concept of fastened earnings ETFs, however regardless of the latest choppiness in bond markets ETFs hold going, rising and altering the character of the underlying market.
The rising recognition of company bond ETFs — and the portfolio buying and selling that they assist allow — makes it simpler for buyers to handle portfolios, lowers buying and selling prices and will increase liquidity, in line with a brand new Barclays report.
This has main implications. Barclays argues that ETFs have dramatically lowered the “liquidity threat premium” — the additional returns that buyers demand to compensate for proudly owning less-liquid securities — and led to decrease yields throughout all the market for US junk bonds.
From the report, written by head of analysis Jeff Meli, with Alphaville’s emphasis:
— New merchandise and protocols within the excessive yield (HY) company bond market — ETFs and portfolio buying and selling, specifically — have improved buyers’ capacity to handle their buying and selling wants at a decrease price.
— A consequence of this enchancment is that the HY liquidity threat premium (LRP) has declined since 2019, each relative to different asset courses and inside the HY market itself. This decline has coincided with each the elevated use of ETFs and the arrival of portfolio buying and selling. We estimate that the yield on HY debt is 50-100bp lower than it might have been absent these enhancements in liquidity administration, after accounting for the extent of rates of interest, the unfold of IG credit score, and the scores composition of the HY market.
— Inside the HY market, the distinction between the yield of bonds with the bottom and highest liquidity, adjusted for downgrade, rate of interest and default threat, has fallen by 30-40% since 2019. We attribute this decline to the flattening of the constructive relationship between yields and illiquidity. Prior to now, HY company bond yields elevated monotonically as liquidity declined. Nonetheless, this relationship has modified just lately, and bonds with medium liquidity have just about the identical yield as bonds with the worst liquidity. This means that the decline within the LRP doesn’t mirror the mixture stage of HY yields, however as an alternative is linked to structural adjustments in how buyers supply and entry liquidity. Per this rationalization, the HY market’s at the moment elevated yields haven’t been seen for the reason that 2015/2016 vitality disaster, when the LRP accounted for 35% of the HY index yield vs solely 17% at the moment.
A 100-basis-point secular decline in common yields is fairly dramatic. It’s excess of you’d count on from a one-notch credit standing improve or downgrade, for instance.
And notably, Meli additionally argues that the erosion of the liquidity-risk premium — and the ensuing decline within the return potential of the high-yield bond market usually — might be driving the more and more ravenous urge for food for untraded personal credit score.
From the report:
Our evaluation has necessary distributional implications for buyers relying on their demand for liquidity and their funding methods. Lively managers, corresponding to HY mutual funds, which should meet each day redemptions and so should commerce rather a lot, have benefited from improved methods to handle liquidity. Additional, energetic managers’ efficiency is evaluated towards their capacity to persistently outperform their benchmark. Whereas the discount in benchmark yields (as a result of decrease LRP) just isn’t related for his or her relative efficiency metrics, the decreased transaction prices enable energetic managers the area to make use of their knowledgeable data to generate alpha, which in precept ought to entice extra curiosity to their funds.
Alternatively, a declining liquidity threat premium has probably made asset allocators, corresponding to insurers and pension funds, worse off. These buy-and-hold buyers don’t handle each day liquidity wants and are far much less delicate to the liquidity of their bond holdings than mutual funds. Therefore, investing within the illiquid HY market offers a horny, and but comparatively risk-free means, to generate additional returns for these kind of buyers.
Because the rewards of investing in HY decline, it’s potential that buyers have tilted portfolios in direction of different asset courses providing extra engaging funding alternatives — corresponding to personal credit score . . . In keeping with Preqin Professional information, an growing variety of pension funds have added personal credit score as an asset class over the past three years, and asset allocations for these (ie, pension funds that spend money on personal credit score) have practically doubled — from 3.0% to five.7%. Equally, insurers proceed to extend the share of personal credit score of their bond portfolios.
Whereas the rise of personal credit score probably has many causes, we consider that the mix of the excessive return hurdles for asset allocators and the shortage of viable alternate options has been an necessary contributing issue. Furthermore, this supply of demand for personal credit score is structural and fewer delicate to the extent of rates of interest or macroeconomic circumstances, and as such, is more likely to be secure by way of the financial cycle.
Intriguing because the argument is, this looks like a little bit of a stretch.
Sure, the rising curiosity in personal credit score has been pushed by the upper (and seemingly smoother) returns on supply in comparison with public debt markets. However it appears extra just like the insane urge for food for personal credit score has lowered its personal liquidity threat premium to minimal ranges. Traders merely appear to be paying up for the privilege of avoiding mark-to-market accounting, moderately than being turned off by the speculation that potential junk bond returns have light.
Nonetheless, it’s potential that the broad yield erosion recognized by Barclays helps stoke the personal credit score increase on the margins. And hey — it’s an excellent argument for pension fund CIOs to make after they argue for growing their personal capital allocations.
Additional studying:
— The personal credit score ‘golden second’
— Bond portfolio trades are low-cost as chips. Why?
— Excessive yield ETF affect on underlying bond market jumps
— The creeping equitisation of credit score buying and selling
