(…) The high-yield boom has packed premiums onto ETFs that may not last. Inflows to high-yield ETFs have been virtually nonstop in the past few years. In order for new units to be created, third parties such as investment banks purchase the underlying bonds in the high-yield market, where transaction costs are high. But such banks will create units to sell to ETF managers only if it’s profitable, or when units are worth more than the cost of the bonds. When the high-yield market was nearly frozen in December 2008, high-yield ETFs traded at premiums of more than 10%, compared with about 1% in today’s healthier market.
What if inflows switch to outflows? As ETFs mature, marginal investor demand will likely decline, especially if the high-yield market falters. Just as investment banks buy bonds to create units, they sell bonds after redeeming units. If the bond market became illiquid again, trading costs would be steep. That could pressure ETF prices down to discounts before investment banks are willing to purchase and redeem units.(…)
Even so, high-yield ETFs offer better liquidity than investors likely can find elsewhere. When high-yield bond markets came to a standstill last year, the ETF market remained active and deep. Investors should just remember such perks don’t come for free.