Liquidity Risks Overhang High Yield ETFs

August 05, 2015

NEW YORK (Reuters) – Shareholders in the AdvisorShares Peritus High Yield (HYLD | D) ETF who sold in late 2014 are probably not the last to pay up for liquidity risk, a growing hazard for some fixed-income investors bracing for the first Federal Reserve interest-rate hike in nearly a decade.

ETFs created in recent years and dealing in often-illiquid or thinly traded junk bonds, emerging market debt and bank loans are an untested market force that may increase selling pressures in a market turndown, analysts say.

The Peritus fund's holders had a rough ride when its heavy holdings of energy-sector junk bonds were badly stung by falling world oil prices. The ETF's holders exited in droves, accelerating trading volumes and forcing HYLD to sell illiquid securities into declining markets at discounted prices. Its $1.1 billion of assets nearly halved in five months, and a normally negligible gap between the worth of its holdings and its share price on exchanges swelled to nearly 7 percent and worsened returns for sellers.

Bargain Buyers
"There were buyers, though buyers at a very discounted rate, given what was going on," said Noah Hamman, chief executive at AdvisorShares. "I was unhappy about some of the discounts we saw."

Federal Reserve interest-rate increases historically exacerbate bond market volatility, but this time investors are worried that hikes may more severely rattle markets, including increasingly risky junk bonds.

Fixed-income high-yield ETFs have grown to $37 billion in assets, up from about $10 billion five years ago. Hedge funds are reportedly readying to profit from a market crisis aggravated by illiquidity, and investors such as Carl Icahn and Bill Gross have raised concerns about liquidity. The worst mistake investors could make, though, is to try to trade during this type of volatility, especially if they're on a long-term horizon, analysts said.

‘Sit On The Sidelines’
"The biggest risk is for investors trying to trade through the temporary liquidity mismatches," said fixed income strategist John Gabriel at Morningstar in Chicago. "If you are not trading, you can sit on the sidelines and just watch."

Wealth advisers should use junk-bond ETFs for holdings that clients will not need for five years, so investors can wait out sell-offs that produce unusual discounts and avoid locking in losses, Gabriel says.

Peritus, now a $350 million fund, was stressed last year that its normally narrow bid/ask spread widened more than 10 times in early December, according to Thomson Reuters data. Some of Peritus' energy holdings barely traded in late 2014, making more likely the liquidity-related difficulties that can depress returns for investors obliged to cash out when net asset values are depressed.

Chart courtesy of StockCharts.com

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