Hidden risks in corporate bond ETFs

Exchange-traded funds (ETFs) tracking bond indices have certainly been in favour in 2012. Having attracted over $50bn in new money in the first eight months of the year, they have accounted for more than a third of all the global ETF market's inflows for this year and have already surpassed 2011's annual total (itself a record).

ETFs offering exposure to corporate bonds are in particular demand, as they provide one of the few ways of generating extra income in the current environment of near-zero official interest rates. But I worry that investors have missed a key risk.

Corporate bond ETFs can be split into two categories. First there are investment-grade ETFs, which hold bonds of a higher credit rating and thus offer a lower yield. Secondly there are high-yield ETFs that own riskier junk' bonds and offer higher yields. Both types have enjoyed an excellent recent run.

The iShares' investment-grade iBoxx Sterling Corporate Bond ETF (LSE: SLXX) is up over 60% since the bottom of the bear market in March 2009. The iBoxx Euro High Yield (junk bond) ETF (LSE: IHYG) is up 20% in the last year. IHYG still offers a total yield of over 6%.

So why am I cautious? One reason is that the liquidity of a more traditional investment, such as a FTSE 100 ETF, and one buying corporate bonds, is fundamentally different. However bad the economy or the equity market gets, you're almost certain to be able to trade easily in and out of the likes of HSBC and BP (ie, leading members of the FTSE 100).

But trading in corporate bonds can easily come to a halt in tough times. That illiquidity is almost certainly worse than it was before 2007's financial crisis. That's because the banks that provide price quotations for corporate bonds can't hold large inventories any more due to regulatory rule changes.

iShares, the promoter of the most successful bond ETFs, argues that this doesn't matter as its funds are now big enough to provide investors with liquidity in the underlying bonds by themselves. But this is an untested theory and reminds me of reassurances made about some structured products that collapsed a few years back.

As long as central banks continue to prop up asset prices and suppress interest rates via QE, nothing drastic should happen to corporate-bond ETFs. But if markets crack, they are potentially riskier than many income-seeking investors realise.

Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe's ETF and index-fund market.