A war of words over junk bonds

Activist investor Carl Icahn has accused BlackRock of offering high-yield bond ETFs to investors who don’t understand the risks.

Is trouble brewing in bond exchange-traded funds (ETFs)? Carl Icahn fears there is. The activist investor has accused investment manager BlackRock (which owns the iShares brand of ETFs) of being an "extremely dangerous company" for offering high-yield bond ETFs to investors who don't understand the risks.

High-yield bonds also known as junk bonds are those issued by borrowers with credit ratings below investment grade. Income-hungry investors have flooded into these bonds in recent years, and ETFs are becoming an increasingly popular vehicle: there are around $37bn in assets under management by high-yield bond ETFs in America, according to data provider S&P Capital IQ. This is still only around 20% of the total amount held by US junk-bond funds, but critics such as Icahn say that ETFs create greater risks than traditional funds.

They argue that the mismatch between the underlying junk-bond market (where many bonds are highly illiquid meaning that they trade infrequently) and the ETF market (where investors expect to be able to buy or sell ETFs whenever they want throughout the trading day)is setting up a potential crisis. As interest rates rise and investors bail out of riskier debt, heavy selling of junk-bond ETFs could lead to problems as the ETFs try to dispose of their holdings faster than the underlying junk-bond market can absorb them.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

"If investors are forced to sell relatively illiquid bonds because of redemptions, they'll take increasingly lower prices so long as the buyers fail to show up," says Josh Brown of The Reformed Broker blog. The result could be a vicious cycle of tumbling prices and panic selling. Defenders of high-yield ETFs naturally reject this scenario.

Critics such as Icahn don't understand how ETFs work, shot back BlackRock CEO Larry Fink: "ETFs create more price transparency than anything that's in the bond market today. To trade ETFs at every minute of every day you have to have a valuation of every bond at every minute."

Regardless of who is right, there are reasons to be concerned. Investors have been so starved of yield that even those with no business in high-risk assets have bought in, high-yield veteran Martin Fridson of asset manager Lehmann Livian Fridson, told The Street website. "Eventually they may realise that they don't have to take that excess risk and they will bail out." When that happens, high yield will see a "messy" bear market, whether ETFs ultimately exacerbate the problem or not.

Piper Terrett is a financial journalist and author. Piper graduated from Newnham College, Cambridge, in 1997 and worked for Germaine Greer and for Adam Faith’s Money Channel before embarking on a career in business journalism. 

She has worked for most top financial titles, including Investors Chronicle, Shares magazine, Yahoo! Finance and MSN Money. She lectures part-time at London Metropolitan University and is the author of four books.