Never Fear the ETF Taper. Credit Funds Have Bigger Ballast

(Bloomberg) -- Investors fearful that a torrent of outflows from corporate bond ETFs presages a world of pain for the asset class, take solace: it's just a drop in the ocean.

Research from Bank of America Corp. suggests high-grade credit continues to swim in a pool of liquidity, with record redemptions from exchange-traded funds of late belying enduring appetite for company debt among retail and institutional money managers.

“For us to be concerned about large overall high-grade outflows – i.e. from bond funds as well - we need to see a much bigger increase in interest rates,” strategists including Hans Mikkelsen and Yunyi Zhang wrote in a recent note to clients.

Investors in the world's third-largest fixed-income ETF -- the iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund (LQD) -- withdrew $921 million last Wednesday, the largest daily outflow since its 2002 inception. That followed a record redemption the previous week.

The selloff was relatively broad. Money managers pulled $14.1 billion from debt funds including ETFs, led by high yield, the fifth-largest stretch of redemptions in the week through Feb. 14, according to EPFR data, spurred by fears over U.S. interest rates. The 10-year benchmark traded at 2.9 percent Tuesday amid fears it could test 3 percent.

Step back, however, and a more bullish picture emerges. Even with the boom in passive investing, ETFs hold just 2.9 percent of the outstanding stock of high-grade corporate bonds, with LQD representing just 0.5 percent. What's more, dedicated corporate bond funds and ETFs have posted $1 billion of inflows so far this year, according to BofA data.

JPMorgan Chase & Co. is also sanguine, suggesting investors shouldn't be overly concerned by the plumes of negative sentiment emanating from ETFs.

“Given record high outflows from U.S. HY bond ETFs, very high short interest ratios and rising costs of funding shorts, bearish sentiment in both U.S. high yield and high-grade bonds appears stretched and looks vulnerable to a reversal,” strategists led by Nikolaos Panigirtzoglou wrote in a recent note.

That's not to say the clout of passive vehicles should be overlooked.

Their holdings as a proportion of traditional high-grade and ETF funds combined stands at a non-trivial 11 percent, according to Bank of America. And as high-beta credit products, which move with the global tide of risk appetite, they can provide useful, forward-looking signals on underlying appetite for corporate obligations.

“Fixed-income ETFs are getting increasingly popular and, as a result, are adding liquidity to the mostly illiquid corporate bond market,” the strategists concluded.

To contact the reporter on this story: Sid Verma in London at sverma100@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Cecile Gutscher, Todd White

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