Corporate ETFs and Risk Appetite

January 24th, 2018 7:14 am | by John Jansen |

Via Bloomberg :

Bond ETFs Awash in Pain May Be Red Flag for Risk Appetite (1)
2018-01-22 14:56:05.415 GMT

By Dani Burger and Sid Verma
(Bloomberg) — U.S. corporate debt exchange-traded funds
have bled a near-historic sum of assets over the past two weeks,
but holders of the underlying securities are paying little heed.
The bonds themselves are enjoying some of the tightest
spreads on record as appetite for new issues remains strong. On
one hand, tax reform, rising oil and global growth may be
fueling demand for yield. Yet the ETFs — in the midst of the
longest outflow streak in at least seven years — point to a
downturn.
The divergence is stumping Wall Street strategists who use
the ETF market not only as a proxy for investor sentiment in
debt, but also as a gauge of risk appetite for equities and
other assets. Though technical quirks associated with ETF
trading may have caused the dislocation, some analysts point to
a simpler distinction: so-called dumb money versus smart.
“The tax package is probably giving institutional investors
more confidence about the shape of corporate balance sheets,”
said Matt Maley, a strategist at trading firm Miller Tabak + Co.
“Thus they might be making up for the selling that is coming
from these products geared towards individuals, who are worried
about the rise in government yields.”
U.S.-listed corporate bond ETFs are headed for a second
consecutive month of outflows, the first time that’s occurred in
at least seven years. The pain is across ratings. The iShares
iBoxx Investment Grade Corporate Bond ETF, LQD, had the biggest
day of losses last week since 2016, while BlackRock’s high-yield
equivalent, HYG, is in the midst of its biggest two-month
outflows on record.
If the withdrawals are a symptom that retail funds are
losing their taste for fixed-income, the impact could be far-
reaching. A tweet from DoubleLine Capital LP co-founder Jeffrey
Gundlach Thursday — who has previously warned underperformance
may portend a selloff for risk assets — noted the gap between
junk ETF prices and stock gains.
Strategists at JPMorgan Chase & Co. expect individual
investors to be the “wildcard” for bond markets grappling with
diminished central-bank stimulus, while dollar weakness may
curtail foreign inflows to U.S. corporate bonds.
Spreads in junk and investment-grade bonds sit near the
tightest since 2007 even after high-yields premiums rose
slightly. Meanwhile, investors pulled more than $1.9 billion
from U.S.-listed corporate bond ETFs in the week to Jan. 19, the
second consecutive five-day period of outflows.
ETF constituents can differ from benchmarks due to
liquidity and other portfolio constraints, so some technical
factors may be at play. LQD, for example, has greater
sensitivity to interest-rate risk, with a modified duration of
8.7 years, compared with 7.6 years for the broader Bloomberg
Barclays U.S. Investment Grade index.
“It looks like constituents — either maturity, credit or
liquidity differences between the two markets — have played a
role, but there does seem to be a general weakening of ETFs
relative to the market,” said Thomas Tzitzouris, fixed-income
research chief at Strategas Research Partners. “At a high level,
we believe that high-yield is running into resistance.”
What’s more, ETFs typically serve as “placeholder” vehicles
in lieu of strategic allocations. Investors, therefore, may be
putting cash into work in the primary market during the January
deluge at the expense of passive instruments.
It’s much faster to make a short, or bearish, bet on an ETF
than through cash bonds, according to Andrew Brenner, the head
of international fixed-income at Natalliance Securities in New
York. Later when traders cover those shorts the ETFs recover, he
said.
“The actual bonds could take a week to move while the ETF
takes 10 minutes,” he said. “But we have seen this before and
the market has held, and then shorts have to grab the ETF so it
outperforms.”
In the short-term, the swelling gap between ETFs and the
underlying market may expose some investors to basis risk, or
the peril of hedging bond exposures through passive investments.
“At the very least ‘credit hedge’ products are
underperforming,” Peter Tchir, the head of macro strategy at
Academy Securities Inc., wrote in a note Friday.  “Whether a
precursor to wider weakness or setting the stage for one gap
tighter back to levels closer to pre-crisis levels is the big
question. With the year off to such a great start, I would err
to the side of caution here. ”

To contact the reporters on this story:
Dani Burger in London at dburger7@bloomberg.net;
Sid Verma in London at sverma100@bloomberg.net
To contact the editors responsible for this story:
Samuel Potter at spotter33@bloomberg.net
Cecile Gutscher, Natasha Doff

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