28.05.2012

By Simon Miller

The rise in the use of exchange traded funds (ETF) by institutional funds is a credit negative action for sponsors according to Moody's.

According to the rating agency, the in-kind redemption of 19.7m shares of State Street Global’s high-yielded bond ETF, the SPDR Barclays Capital High Yield Bond ETF, on 10 May gave an investor control of bonds directly from the fund’s portfolio and signified institutional investors’ increasing use of ETFs that had long been marketed to retail markets.

Writing in Moody’s Weekly Credit Outlook, vice-president – senior credit officer Neal Epstein, pointed out that normally, investors traded ETF shares in the secondary markers.

“Institutional investors, typically market makers, may trade directly with a fund through in-kind transactions of 100,000-share blocks known as “creation units,” which are exchanged for baskets of securities replicating the fund’s benchmark,” he wrote.

As a result the rising institutional use of ETFs was credit negative for ETF sponsors such as Blackrock, with its iShares, Invesco, with its PowerShares, and State Street with its SPDRs, “because retail investors and their advisors would be deterred from holding ETFs if they are exposed to elevated volatility and execution risk from large trades".

"In addition, such transactions elevate the potential for additional regulatory scrutiny and increased compliance costs for these products if their use as vehicles for implementing arbitrage strategies proves to amplify systemic risks," he commented.

Epstein said large block trades appeared to have affected the relationship between JNK’s price and net asset value (NAV), causing investors trading losses.

He added: that although it was difficult to know for sure, the incentive for this trading activity in high yield bond ETFs could have resulted from arbitrage opportunities related to anomalous pricing in the credit default swap market created by JPMorgan Chase’s outsized selling of the Markit CDX index.

Epstein said another possibility was that mispricing in credit default swaps caused traders to prefer the use of ETFs as hedging vehicles, which may explain variations in short interest.

“Whatever the reason, retail investors in ETFs generally do not expect this type of trading behaviour,” he added.

Epstein warned that the rising use of ETFs as rapid trading vehicles by institutional block-traders and hedgers seemed to be increasing investors’ risk.

He concluded: “This development dilutes the marketing message of industry sponsors that have promoted ETFs as a superior investment technology for retail investors, as well as invites additional regulatory oversight, potentially undermining the credit positive benefits ETF sponsors have enjoyed from their success to date.”