Fixed income ETFs could amplify bond market volatility, says Fitch

Aug 20th, 2013 | By | Category: Fixed Income

Exchange-traded funds (ETFs) are playing a more significant role in US fixed income markets, particularly the corporate high-yield segment, according to a recent report from Fitch Ratings, a credit rating agency.

Fixed income ETFs could amplify bond market volatility, says Fitch

Fitch suggests that increased ETF trading volumes might amplify overall bond market volatility.

Their relevance has increased with the reductions in dealer inventories of corporate bonds, as new US and global financial regulations have increased capital and liquidity requirements on banks’ trading activities.

Fitch notes that the five largest investment-grade corporate bond ETFs total about $46 billion in assets as of end-June 2013, compared with dealer inventories of about $9 billion.

For high-yield corporate bonds, ETF assets are about $28 billion, roughly four times the $7 billion in dealer inventories.

Although US corporate bond ETF assets total less than 2% of the US corporate bond market, their influence on trading activity is relatively more significant, particularly for the high-yield sector.

Average daily trading volumes on a weekly basis for the five largest high-yield corporate bond ETFs 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.

This investor appetite for liquidity might partly explain why ETFs comprise a relatively higher proportion of trading in high-yield corporates versus in investment-grade bonds. ETFs provide a mechanism for fixed income investors to trade more actively within the high-yield market, helping to compensate for the relatively lower liquidity in the underlying bond market.

However, Fitch suggests that increased ETF trading volumes might amplify overall bond market volatility, as redemptions of ETFs can, in turn, drive selling in the underlying bonds.

The rating agency cites research from the Federal Reserve Bank of New York which indicates that an investor or dealer liquidation of more than $250 million in corporate bonds in one day could begin to adversely affect corporate bond prices.

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