New Junk-Bond ETFs Are Born of Fed Moral Hazard
(Bloomberg Opinion) -- In case there was any uncertainty about the moral hazard created by the Federal Reserve’s decision to buy junk-bond exchange-traded funds, a group of former senior leaders at BlackRock Inc., JPMorgan Asset Management and HSBC is leaving no room for doubt.
BondBloxx Investment Management LLC, which launches on Thursday, plans to run seven separate ETFs that break down the high-yield debt market by sector, Bloomberg News’s Tasos Vossos reported. It intends to use the roughly 2,100 bonds in the ICE BofA U.S. junk bond index to fill funds focused on financial, industrial, telecommunications, health-care, energy, consumer cyclical and consumer noncyclical companies. The members of BondBloxx’s team have collectively launched 350 ETFs in their previous roles.
At first glance, this looks like a gutsy move less than two years removed from the onset of the Covid-19 pandemic and the shocks felt across the fixed-income markets. The iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG) fell 22% in the span of a month through March 23, 2020. The largest ETF covering high-yield municipal bonds (ticker: HYD), an even more illiquid corner of the market, at one point traded at a stunning 28% discount to its net asset value as traders feared impending fire sales from mutual funds in the space. The prospect of BondBloxx running ETFs with a few hundred securities each seems like asking for trouble during the next credit crunch.
Of course, that’s assuming there will ever be another severe credit squeeze. On the same day HYG hit its low, the Fed unveiled its Secondary Market Corporate Credit Facility, granting the central bank power to buy U.S. investment-grade corporate bonds and ETFs tracking that market. Less than three weeks later, it added the ability to buy ETFs “whose primary investment objective is exposure to U.S. high-yield corporate bonds.” That last part in particular defied explanation and created obvious moral-hazard risks.
It shouldn’t be lost on anyone that most of the BondBloxx founders have at some point worked for BlackRock, which the Fed chose to manage assets for the corporate-credit facilities. As of Aug. 31, all of its holdings either matured or were sold, but the market impact remains. The average yield spread on investment-grade debt is 86 basis points, near a record low, while junk bonds offer a pickup of 300 basis points, well below the average of 527 basis points over the past two decades.
Leland Clemons, a member of BondBloxx’s founding team and the former global head of markets at BlackRock iShares, told Vossos that “if you look at how fine the equity landscape has been cut, there is simply not the same level of precision in fixed income.” But there’s a good reason for that: Bonds are much more difficult to trade. Yes, portfolio trading is helping to shift baskets of securities around, but it will only do so much in a scenario in which mutual funds are overcome by outflows.
Consider the aforementioned high-yield muni ETF. As I wrote in March 2020, it broke down because it traded debt issued for senior-living facilities at drastically reduced prices — 53 cents on the dollar from 113 cents previously, or 38.5 cents from 100 cents. It doesn’t take much imagination to think that a fund focused exclusively on speculative-grade health-care companies could have faced similar pressure. And risky energy firms are often prone to bouts of turmoil.
It could be worse — trying to divide up the junk-bond market through open-end mutual funds could lead to outright implosions. The upside of the ETF structure is that they can survive for weeks or months trading at a discount to their NAV on an exchange, similar to closed-end funds. Open-end mutual funds must sell assets to raise cash to meet redemptions, even if the market is frozen.
Still, it’s hard to divorce this plan for niche high-yield ETFs — and the industry’s growth in general — from the new Fed precedent of backstopping the bond markets during times of trouble. These funds will be born of moral hazard, and junk-bond investors will have to live with the consequences.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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