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The Liquidity Put


We all love to get something for nothing.  What if I told you some folks like to pay something for little to nothing?

In the world of non-investment grade bonds, that is what you may be getting – when they are within an exchange traded fund (ETF).

The theory for owning ETF’s with high yield bonds in them, is to get exposure to the sector, diversification, and make them more easily traded (or liquid in industry parlance).

The largest funds, JNK and HYG, control huge amounts of bonds – about $27 billion.  Liquidation calls, when the ETF shares are sold and the ETF manager sells the cash bonds within the fund, have now gotten to the point where a five percent liquidation would be difficult for Wall Street to easily absorb or re-sell.

Part of the reason for owning these ETF’s is the ability to sell quickly; however these structures are new and haven’t been tested by a rising interest rate or other market events.  So how realistic is it for you to think you can “put” the bonds back to the Street without meaningful price impact?

It is also important to note, that absolute yield levels are near historic  multi-decade lows.

We can also use option theory to model if you are in fact are likely to get a reasonable price for a sizable order, by comparing the trends in bid-ask spreads of the underlying cash paying bonds and the ETF trading volume.  We’ll defer posting on what that implies now, as we are in the middle of year-end client meetings – and they deserve to hear this commentary first.

However, we will note that all the signs of overheating are in place: 1) bondholder protections on new deals are weaker again, 2) absolute yields are not reflective of normal default levels, 3) there are large non-traditional buyers in the sector, 4) the trend in credit ratings upgrade seems to have plateaued,  4) public concerns by the Federal Reserve,  and 5) It’s been +4 years since the last credit shock.

As of today, we do not own either of these securities in our firm or personal accounts.