You know there’s probably something a bit quixotic about the crusade to warn of an eventual blowup in the high yield ETF space. I’ve been railing against those products for years – long before Heisenberg was Heisenberg.
The blowup of the short vol. ETPs reignited the debate and there’s certainly a sense in which the wipeout of the Seth Golden crowd seemed to presage something – although what that “something” is isn’t yet clear.
The obvious conclusion to draw is that to the extent damn near everything has become an expression of the increasingly ubiquitous short vol. trade, XIV and SVXY were just the tip of the proverbial iceberg. But that’s kind of an endless regression. I mean, don’t get me wrong, I’ve been predisposed to shrieking about things that represent “implicit” short vol. strategies, but the waterfall effect doesn’t affect all of those strategies equally and if you’re not careful, you can wind up in the crowd that spends their time penning short vol. manifestos that read like Revelations.
When I talk about the high yield ETF space, I generally focus on the underlying liquidity mismatch which, to me, looks incontrovertible. Howard Marks and Carl Icahn have variously maligned the same structural problem. I have yet to read a refutation of those criticisms that doesn’t essentially beg the question by positing some semblance of benign market conditions. You cannot promise intraday liquidity against a basket of relatively illiquid assets. It’s philosophically impossible. Obviously, it can work for a while (and theoretically indefinitely) by way of an intervening mechanism that allows participants to arb away disconnects. But if that arb relies on people not being in panic mode or being otherwise willing to catch falling knives, well then it stands to reason that in a pinch, the intervening mechanism that allows for the transformation of illiquid assets into ETF units with intraday liquidity will cease to function and at that point, the ETF is only as liquid as the assets it represents.
With apologies to all of the very smart people who are involved in this space on a daily basis (and many of them are undoubtedly far smarter than I am), that model will break. It’s a foregone conclusion. It’s preordained. The only way it can work in perpetuity is if there is never an acute situation in markets that causes high yield to get dumped. If the flows become unidirectional in these products – that is, if everyone is selling and thus outflows aren’t diversifiable – someone, somewhere is going to have to resort to the cash market for the underlying bonds and if that market approximates fire sale conditions, well then it’s adios amigos. This can be mitigated if fund sponsors have set up emergency liquidity facilities with banks, but there’s no way that would be adequate if the situation were bad enough.
Earlier this month, when the bottom was still falling out for equities, we suggested the high yield ETFs might be about to get tested. You can read that post here: “Are Junk ETFs About To Get Stress Tested As High Yield Cracks?”
Outflows from corporate credit funds accelerated in a big way in the week through Wednesday, although the focus was on IG and specifically LQD which, frankly, is hemorrhaging. Of course the IG story is different from the HY story for myriad reasons, most of which are obvious.
Ok, so one of the big stories during the selloff was the extent to which it was largely an equities-centric phenomenon although as noted in the post linked above, there for a minute it was looking dicey for HY, despite the solid economic backdrop and the benign default environment which, all other things equal, should keep things under control.
Well Deutsche Bank is out with an attempt to quantify what the impact of a given VIX spike should be on IG and HY spreads and, in turn, on IG and HY ETFs. The implication (although they don’t really get too far into this) is that eventually, outflows from those products could present something that approximates a serious risk to markets. Here’s an excerpt from DB’s note:
Our colleagues in equity derivatives had discussed the amount of vega that short vol funds would have to buy following an increase in VIX, which effectively helped to magnify a justifiable increase in volatility. With the washout in those funds, the next nexus of risk in our minds is credit space, particularly given the relative under-reaction thus far. Given our modeled impact of VIX on IG and HY spreads, we estimate that a 1 point rise in VIX is worth -0.6% to IG ETFs in aggregate, and -1.3% to the universe of HY funds. Thus far, an index of IG ETF’s has fallen 1.2%, whereas the VIX shock should have pushed it 3.3% lower, and an index of HY funds is down just 2% versus a VIX implied drop of 7.2%. The concern would be that if credit spreads do indeed reprice to higher volatility, the drawdown in credit ETFs could trigger meaningful liquidation, resulting in further pressure on spreads.
That last bit hints at a self-feeding loop – or, the same kind of self-reinforcing dynamic that played out with the short vol. ETPs. Spreads reprice higher, leading to outflows from the funds, which leads to more spread widening, which leads to more outflows, and around we go.
With that, here is Deutsche’s attempt to put some (more) numbers to this:
To attempt to put some numbers around it, empirically a 1% m/m selloff in IG ETFs is consistent with a 1.9% decline in IG ETF AUM (currently about $130bn), meaning a 0.9% liquidation; for HY ETFS, a 1% sell-off equates to a 2.8% drop in ETF AUM (currently about $45bn), and therefore a liquidation worth 1.8% of AUM. Assuming the full repricing implied by the move higher in volatility occurs, it would imply $3.7bn redemption in IG funds, and about $6bn in HY ETFs (and the longer that VIX remains elevated, the more this risk grows). The acute risk for the credit market should such a flow materialize should be for HY, conditional on how concentrated it is – average daily volume in IG was about $17bn last year, whereas for HY is was $7.7bn. Should credit sell-off to where the current level of volatility implies, liquidity would likely deteriorate anyway, and the added pressure from fund outflows would likely further exacerbate the spread widening.
And see this is a readily identifiable risk. And while it might seem far-fetched today, what I would say is that the ETF experts out there (and that of course includes the issuers themselves) should at least acknowledge that this is a possibility. I mean you don’t want to incite a panic or otherwise talk bad about your own products, but there are ways to warn people without doing either of those things.
It’s always the stupidest shit that blows up first and when that happens, everyone can kind of shrug it off and say “well, those things were inherently dangerous”. But if conditions continue to deteriorate, ostensibly “safer” products start to implode and then it gets harder and harder to explain to investors why no one seemed to have been accurately appraising risks.