A risk to consider for high-yield bond ETFs

Posted on: March 2, 2010 in: Uncategorized with 0 comments

An article in today’s Wall Street Journal warns of the liquidity risk inherent in high-yield bond ETFs. These ETFs typically hold bonds issued by companies with lower credit ratings.

In Canada, we have the Claymore Advantaged High Yield Bond ETF (CHB), which has exposure (through a derivative contract) to a portfolio of US names like Ford, GM, Macy’s and Sprint. In the US, there’s JNK, the SPDR Barclays Capital High Yield Bond ETF.

When markets are in freefall, as happens now and then, it can be hard to find a buyer for riskier securities such as high-yield bonds, except at fire-sale prices that are completely disconnected from actual fair value.

A high-yield bond ETF offering continuous liquidity, faced with panicked sellers, is forced to sell its holdings at the fire-sale prices and realizes a loss. Compare that to the holder of a high yield bond who can ignore the ravings of Mr. Market and sit tight until normality returns.

The article makes the point that unlike most ETFs, high yield bond ETFs often trade at prices far from their fair value. It could be at a premium or a discount. And while this is not a reason to avoid bond ETFs, it is something to be aware of.

As always, your questions and comments are welcome.

Tomorrow, I’ll be attending “Global Credit Meltdown!!!!”, which could be the title of a sequel to an Al Gore movie but is actually a talk at the U of Toronto Law Faculty. More details here.

All the best,
Vikash

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