Are ETFs Distorting This Red-Hot Market?

Exchange-traded funds have opened up a whole new world of investment opportunities for many investors. It's never been easier to get exactly the exposure you want to just about any type of investment you can think of.

But in some markets, ETFs aren't just popular; they've effectively displaced trading in the underlying assets that those popular ETFs own. One of those markets happens to be extremely popular in its own right because of its rich income opportunities even in an environment in which income is hard to come by.

Finding treasure in junk
Junk bonds have become a hotbed of activity for income investors seeking to increase their cash flow. Unlike Treasuries and high-grade corporate bonds, many of which have seen interest rates fall so low that they don't even keep up with inflation, junk bonds are still offering reasonably solid rates. Although the creditworthiness of many junk bond issuers is questionable, favorable economic conditions have kept default rates relatively low, allowing investors to keep much of the spread as additional profit.

Because of the logistics of bond trading, investing in the bond market has always been more challenging for individual investors than buying and selling stocks. That may be one contributing factor to why junk bond ETFs SPDR Barclays High Yield Bond (NYSEMKT: JNK  ) and iShares iBoxx High Yield Corporate Bond (NYSEMKT: HYG  ) have attracted billions of dollars in assets, but according to a recent article from Bloomberg, it's not the only factor.

Volume in junk bond ETF shares has almost doubled in 2012 over last year's levels, and ETF trading now represents a substantial amount of the total daily trading in individual junk bonds themselves. With current estimates putting ETF volume at 11.5% of bond trading, some analysts are concerned that as large institutions start using ETFs because of their speed and ease of use in gaining quick exposure to the asset class, it could lead to distortions in the market versus bonds in the most commonly followed bond indexes versus others outside those indexes.

Keeping the bonds flowing
One reason junk bonds may not start facing systemic problems is that the sheer volume of newly issued debt has been high. Even though junk bonds offer higher rates than investment-grade debt, the absolute level of junk bond rates has fallen substantially, giving companies every opportunity to refinance existing debt and get more from the credit markets.

Still, whenever indexes are involved, the potential for distortions exists. In the stock market, Apple's rise has led to some major concentrations in the tech stock even among some of the most popular ETFs in the marketplace, including PowerShares QQQ (NASDAQ: QQQ  ) which has 16% of its assets dedicated to the iDevice giant. Similar effects in other markets have actually hampered the effectiveness of ETFs aiming to track those markets, with issues arising such as contango in futures-market-tracking ETFs and other similar effects stemming from the need to roll some investments forward on a regular basis.

The structure of junk ETFs and the indexes they follow seem to address some of those concerns. Within the SPDR junk ETF, no one bond makes up more than 1.5% of the overall portfolio, but offerings from Sprint Nextel (NYSE: S  ) and HCA (NYSE: HCA  ) represent $165 million to $175 million of the ETF's overall assets. That's a drop in the bucket compared to the overall debt levels of those companies, both of which exceed $20 billion. But for companies with less debt, the potential exists for possible complications down the road.

Be careful
With rates on junk bonds at historic lows, smart investors have to be sensitive to the risks involved in owning them. Despite the fact that junk bond ETFs are easy ways to get broad exposure to the market, the rise in their popularity has created some new risks that you can't afford to ignore.

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