Bond ETF Investors Rocked by Trading Turbulence

By Hal M. Bundrick

NEW YORK ( MainStreet)--Rapid trading of fixed income exchange-traded funds (ETFs) could be adding significant risk to an investment long regarded as "safe," according to a Fitch Ratings report. The well-known provider of credit ratings and commentary notes that while bond ETFs are playing a more significant role in U.S. fixed income markets, particularly in the corporate high-yield segment, that popularity is also a driver of volatility.

While U.S. corporate bond ETF assets account for less than 2% of the U.S. corporate bond market, their influence on trading activity is relatively more significant. Fitch notes that the average daily trading volumes (on a weekly basis) for the five largest high-yield corporate bond ETFs has more than tripled, from about $470 million in early May to more than $1.5 billion in early June.

"This ramp-up in trading activity points to the value of ETFs for investors to rapidly enter and exit fixed income positions during a period of market turbulence," Fitch analysts say in the report. "However, the increased ETF trading volumes might also amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds."

Fitch refers to Federal Reserve Bank of New York research that indicates an investor or dealer liquidation of more than $250 million in corporate bonds in one day could begin to "adversely affect corporate bond prices."

The firm says that the widespread acceptance and utilization of bond ETFs within U.S. fixed income markets, particularly corporate bond ETFS, has increased with the reduction in dealer inventories of corporate bonds. This coincides with new U.S. and global financial regulations that have or will increase capital and liquidity requirements on bank trading activities.

"Other than this most recent bout of volatility, corporate bond ETFs, at their current scale, are relatively untested in a stressed environment," the analysts say.

Fitch's sample is based on the top five high-yield and top five investment grade corporate bond ETFs, as determined by total assets as of June 28, 2013.

--Written by Hal M. Bundrick by MainStreet