By Jared Dillian
(Bloomberg View) --When you look back at the top financial innovations of the last 10 to 20 years, the first thing that comes to mind is usually not exchange-traded funds that own high-yield bonds.
I traded ETFs for a living in the last decade, and during that time I saw illiquid assets become highly liquid. For example, a basket of Russell 2000 stocks were impossible to trade in the early 2000s. By the late 2000s, though, it was possible to transfer risk of up to $50 million in small capitalization stocks with almost no impact on execution.
The same was true for emerging-market stocks. As recently as 15 years ago, they traded by appointment. Then, just a few years later, it was possible to transfer risk of up to $50 million with almost no impact. Let’s reflect on that for a second: Capital markets have become so advanced that you can take a basket of stocks from dozens of different countries, in different sectors, in time zones across the world, and you can execute a gigantic trade with transactions costs of just a few basis points. And that doesn’t even include the options market tied to EM, which is one of the most liquid in the world.
Corporate bond ETFs came on the scene in the latter part of my trading career. Today, a basket of high-yield bonds trades “like water,” but that wasn’t always the case. Two years ago, the billionaire financier Carl Icahn compared high-yield ETFs to instruments that played a role in the financial crisis, and said that BlackRock, a major purveyor of the products, was a “dangerous” company. It seemed like a reasonable statement to make at the time, as liquidity in the corporate bond market was exceptionally poor (primarily because of the Volcker Rule to keep banks from engaging in risky practices). These ETFs haven’t “blown up” yet, and I doubt that they ever will. There is nothing particularly odious about a plain vanilla ETF that owns securities like stocks or bonds. It is not much different than a mutual fund, except for the legal structure.
But there is one crucial difference: Because an ETF trades intraday on an exchange just like a stock, there is the possibility that its share price can briefly diverge from its net asset value by a significant amount. That’s much different than most equity ETFs, as the equity markets are electronic and there are so many electronic market makers that seamlessly arbitrage away the difference between the underlying basket of stock and the ETF's NAV. Sure, the hugely popular $240 billion SPDR S&P 500 ETF deviates from its NAV all the time, but only for microseconds before it is arbitraged back into place.
The high-yield debt market, by and large, is still a voice market in that trading is done over the phone. If the market “crashes,” with or without an exogenous event, my guess is that there is the potential for a high-yield bond ETF to trade at a 5 percent to 10 percent discount to its NAV. Through arbitrage, the underlying bonds will eventually “catch up” with the ETF, but it may take several hours, or longer, but we don’t really know. Yes, these ETFs were around during the financial crisis of the last decade, but they had a fraction of the assets -- and trading volume -- that they do today. They are untested.
Some have asked whether having a liquid vehicle for an illiquid asset class will actually exacerbate volatility, especially in a crisis. Well, did bond futures increase bond market volatility? Did VIX futures increase the volatility of volatility? In both cases, the answer is no, even after giving people the ability to trade with leverage, which the biggest high-yield ETF, the $18 billion iShares iBoxx High Yield Corporate Bond ETF does not.
Instead, the high-yield ETF would be “open for business,” enabling a healthy transfer of risk when liquidity in the underlying bonds dries up. The ETF then becomes a form of price discovery, where the price of the ETF is the best guess of where the bond market will open once it begins trading. Think of what the high-yield world would look like in a crisis without the ETF: nothing trades and people watch helplessly as positions are relentlessly marked lower. That sounds a lot worse than panicking and selling the ETF when its price gaps below its NAV only to see it recover if the dislocation turns out to be of no consequence.
In that case, you look dumb because you sold it in the hole. Your argument is going to be that the ETF broke, that it ceased functioning, that it did not reflect the value of the underlying securities. The financial press will be no help. It’s already quick to point out when ETFs decouple from their NAVs, even when it's for market microstructure reasons, and broadly interpreting the developments as evidence of ETFs “not working,” resulting in a “loss of confidence.” I assure you, BlackRock will be on the receiving end of withering criticism for a product that actually improves the functioning of capital markets.
But think about the miracle of modern capital markets. We’ve been able to securitize just about every asset class imaginable, with near limitless liquidity. Modern investors can take a view on Poland, Vietnam, the VIX term structure or even merger arbitrage spreads. The choices available to investors are astounding and the transactions costs are relatively inconsequential. Things have never been better.
Beware financial Luddism. If technology and innovation are good when it comes to, say, Amazon.com, they are also good for your brokerage account. There is always debate about which financial innovations have made people’s lives better. These debates are usually settled with the passage of time.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World."
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