A mystery has underpinned recent comings and goings of money in the $1.3 trillion US high-yield bond market.
Over the past month, the biggest junk-bond exchange-traded fund has experienced extraordinary record-breaking daily withdrawals even though the broader market has encountered relatively little turbulence. In fact, these ETF flows have had little to no correlation with mutual-fund deposits or other gauges of investor demand. They are often followed or preceded by huge deposits.
One reason for such activity is that an increasing number of bond dealers are using BlackRock’s $14.9 billion junk-debt ETF the way they used to used their own stockpiles of riskier bonds. Rather than hold assets that could lose value and would require them to hold extra capital, these banks are instead relying on this fund to be an easy source of bonds when clients want them.
Here’s how it works: A client gives money to a dealer to buy a certain amount of high-yield bonds. The broker then uses the money to buy ETF shares that they can then redeem in kind for the underlying bonds. The broker then sells some or all of the bonds to the client.
The evidence for this can be found in plain sight. Flows in and out of the biggest junk-bond ETF have been increasingly volatile, even though the fund’s shares haven’t been particularly jumpy. Trading volumes in this fund have generally trended up, but they haven’t been remarkably high on the days of the biggest withdrawals. Trading in the underlying junk-bond market wasn’t particularly elevated on those days either.
At the same time, Wall Street banks’ net holdings of junk bonds have been shriveling up. While dealers used to use their own money to opportunistically move in and out of markets, they’re increasingly opting to just match up buyers and sellers. The advantage is that dealers can earn a commission on speculative trades without taking on too much risk. The disadvantage is that it can be difficult to quickly find both sides of a trade, slowing down activity considerably.
ETFs have become a convenient solution for some dealers. Unlike mutual funds, which respond to client withdrawals by giving them cash, ETFs offer to exchange shares for baskets of the underlying securities. And trading in the shares of BlackRock’s high-yield fund have swelled in recent years, making it easy to get a hold of them when needed.
This trend does have one big drawback. It suggests that dealers are getting out of the practice of sourcing buyers and sellers for bonds, meaning that they’ll be less equipped to deal with a quickly deteriorating market.
Let’s say a slew of big investors turn to big banks, looking to sell the same high-yield bonds that they’re buying now. Banks would have to find buyers for them, which may be difficult at such a time. If they all stampede to deposit the bonds with BlackRock’s ETF in return for shares, which they then seek to sell, the ETF shares would plunge in value so quickly that they could spur panic among the broader market, which often looks to this fund to determine market values.
In the meantime, dealers are happy to rely on their auxiliary balance sheet.