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The Danger Of HY ETFs

Tyler Durden's picture




 

Via Peter Tchir of TF Market Advisors,

The fact that the High Yield ETFs are trading at a discount should be a big concern to anyone in the high yield market, not just those who own the ETF.  There is a real risk that this discount can translate into arb activity which leads to further declines.

With the ETF’s trading at a discount, the trade would be to sell bonds in the market and to buy shares.  They would then deliver the shares to the ETF providers as a “redemption” and take the bonds to cover the ones they shorted.  Although this has the appearance of being risk neutral, my experience is that it can become a big driver.  I also don’t think many HY bond traders or ETF desks have seen this scenario play out in the credit markets.  We saw a bit of it on the way up, many of the shares the ETF’s “created” were for ETF arb clients, but on the way up, where those participants were buying bonds, no one seemed to care much.  In a downside scenario it can be far worse.

I will walk through a rough example of what used to happen in CDS with “index” arb, and I don’t see what it wouldn’t apply to the ETF’s if they remain at a discount.

Assume there are two virtually identical companies and most of the time their CDS trades roughly in line.  Then one day you notice that over the past week, both went from trading at about 90, to one trading at 100, and the one that is in the index trading at 110.  Many accounts will look at this and determine that it doesn’t make sense.  They may sell protection on the name at 110 thinking the market has moved “too far too fast”.  They may put a “pairs” trade on and buy the one at 100 and sell the other at 110.  Neither are bad trades, but what they have missed, is the overall weakness in the market (that saw even the non index name to move 10 bps wider) has been priced into the CDX indices.  They are say trading at 115, in spite of fair value being 110 for example.  They tend to trade “rich” or “cheap” to fair value based on market sentiment.  Hedgers in particular like to be “temporarily” short the liquid index, while retaining specific (and usually less liquid) credit bets.

The “index arb” clients will come in and pay 110 for the “index” name, while selling the index at 115 (it is more complicated than that, but that is the basic premise).  The “arb” trader doesn’t care if 110 is a “good” or “fair” price for that CDS, they only care that they can buy all the names in the index at a spread tighter than where they can sell the index.  That is it.  They have no interest in buying the name that trades at 100.  They only care about the richness or cheapness of the index versus the single names.

What tends to happen next, is hard to explain, but seems to happen all the time.  The single name traders who sold protection feeling it had gone too far, start having difficulty finding sellers to take the other side.  They are getting long credit risk.  What do they do?  They buy protection on the index because somehow it makes them feel better than just closing out their position.  Effectively single name desks put on the opposite trade as the arbs.  Doesn’t make sense, but happens all the time.  So by buying the index as a hedge, they ensure that it continues to trade cheap, meaning that the index arbs will be back to buy more of the single name.

But why won’t others sell that name or put on the pairs trade?  The problem here is that the spread between the index and non index name continues to widen.  So after some decent sized arbs go through, the names now trade at 105 and 120.  Anyone who sold at 110, thinking to make 10 to 20 bps, just lost 10 bps.  What is the probability that a) they add more, b) they sit tight, or c) they get stopped out on some?  I can almost guarantee that option a is the lowest probability.  Similarly, anyone who put on the “pairs” trade at 10 bps, is now down 5 bps since the spread is 15 (and that ignores bid/offer).  These people are more likely to add to the position, but even there, people start getting nervous that there is something really wrong with the one company.  That fear creeps in.  In credit, being wrong means instead of earning 1.1% per annum you lose 60%.  That fear, whether rational or not, makes it difficult to find sellers of protection.

So the “cheapness” of the index feeds on itself and creates a feedback loop that drives all spreads wider.  The index names get hit the worst, but everything moves.  It doesn’t end usually until the index is at a level that new entrants come into the market to sell the index, which is not only at a  good level, but very cheap to fair value.

I am very concerned that this same process can occur in the HY bond market and liquidity, as bad as it is in a strong market, is far worse in a down market.  As of yet there is no sign that this is happening in a meaningful way, but JNK has seen outflows for a few days and HYG saw outflows yesterday.

 

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Wed, 04/11/2012 - 10:38 | 2334417 Everybodys All ...
Everybodys All American's picture

looking for more and more bizarre trading ... until the entire trading activity is owned by the FED/primary dealers. Funny how the market can go down on millions of trades and then go up nearly to the same levels on hundreds of trades.

Wed, 04/11/2012 - 14:26 | 2335251 PayneNita
PayneNita's picture

my classmate's sister makes $62 hourly on the laptop. She has been unemployed for 5 months but last month her pay check was $13843 just working on the laptop for a few hours. Read more on this web site ....  http://bit.ly/FPPP3j

Wed, 04/11/2012 - 10:40 | 2334419 SheepDog-One
SheepDog-One's picture

'Danger' in these markets? Bah....the Bernank's got this handled! Just print and pump and keep hoping retail shows up to buy trillions in fake bubble stocks off the banksters hands...what could possibly go wrong?

Wed, 04/11/2012 - 10:42 | 2334427 vmromk
vmromk's picture

Until the "Bernank" is removed from his position, there is danger in every single "paper" asset.

Wed, 04/11/2012 - 10:45 | 2334438 The Axe
The Axe's picture

Same fucking story  down days huge volume...up days   volume disappears...????????

Wed, 04/11/2012 - 10:46 | 2334440 scatterbrains
scatterbrains's picture

It's too early to make anything of it but since Blythe's CNBC interview copper has formed a nice little declining trend channel while silver is fighting to stay above water, diverging away from copper.  Did JPM stop hedging their silver shorts with long copper?  Anyway it's way too early and meaningless so far.

Wed, 04/11/2012 - 10:46 | 2334447 RiverRoad
RiverRoad's picture

 Just learned that T. Rowe Price is closing their High Yield Corporate Bond Fund to new investors this April 30th and they will no longer allow their shares to be carried on the books of some brokerages.  To my knowledge they have never closed this very large fund before in the decades of it's existance.  Some black swan is assuredly swimming this way.

Wed, 04/11/2012 - 10:49 | 2334454 SheepDog-One
SheepDog-One's picture

Bernank, Geithner, ObaMao, clowngress, must all be removed from their positions. 

Wed, 04/11/2012 - 10:50 | 2334456 Stax Edwards
Stax Edwards's picture

They would then deliver the shares to the ETF providers as a “redemption” and take the bonds to cover the ones they shorted.

Hey Peter, expand on the mechanics of this "redemption" of ETF shares for the underlying.  April 1 was 10 days ago.

Wed, 04/11/2012 - 10:56 | 2334467 Slope of Hope
Slope of Hope's picture

The ETFs appear to be trading at a premium today - JNK 38.88, JNK.IV 38.78 - HYG 89.17, HYG.IV 89.06. 

Wed, 04/11/2012 - 11:13 | 2334538 buzzsaw99
buzzsaw99's picture

pig bernank will buy them.

Wed, 04/11/2012 - 12:33 | 2334800 hedgeless_horseman
hedgeless_horseman's picture

 

 

In credit, being wrong means instead of earning 1.1% per annum you lose 60%.

Too few get this point.  For those that do, being right can also mean you earn the 60%.  Two sides to every trade...even in credit markets.

Wed, 04/11/2012 - 13:52 | 2335094 saywhat
saywhat's picture

Are we possibly being diagnosed with "Swanitis"?

(Black Swans everywhere)

Just askin

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