Credit and corporate bond ETFs
How can credit and corporate bond ETFs be structured?
In common with most ETFs, they can use physical or synthetic replication of an index. The differences between credit and other ETFs arise in the types of instruments available for synthetic replication.
They can use physical or “cash” bonds – buying actual bonds. They will often tend to trade using baskets, trading multiple bonds at once at certain times of the month or year, which may coincide with index rebalance dates, because this can be cheaper than trading individual bonds on a more ad hoc basis.
One example of an ETF using physical replication is run by the world’s largest bond manager, PIMCO: US Short-Term High Yield Corporate Bond Index UCITS ETF EUR (Hedged).
ETFs can also use “synthetic” instruments such as credit index futures, listed on exchanges such as the ICE. A swap with a credit index is a way of getting exposure to the index, but is not the same as a credit default swap.
For instance, ProShares Short High Yield (SJB), launched in 2011, uses a swap with the MARKIT IBOXX $ LIQUID HIGH YIELD INDEX.
ETFs can also use single name credit default swaps (CDS) based on the credit spreads of individual corporate bond issuers.
Some ETFs might use two of three of these methods, depending on the liquidity, relative valuation and availability of instruments. For instance, not all company bonds have an associated CDS contract, in which case buying the cash or physical bond may be the only choice. Sometimes the CDS or cash bond might be cheaper or more expensive so active managers may switch between them to get the best value.
An ETF that ordinarily uses physical bonds, might occasionally rely on indices as a quicker way to deploy a large inflow, or meet a large redemption, avoiding the need to trade large numbers of individual bonds – especially at times of the month when basket trades cannot be easily availed of. And in stressed market conditions if bid/offer spreads widen out on individual bonds, they may also determine that an index could be cheaper.
Are there credit default swap ETFs?
ETFs could track an index that is itself based on CDS. For instance, Xtrackers II iTraxx Crossover Short Daily Swap UCITS ETF 1C, is based on the The Markit iTraxx® Crossover 5- year Short TOTAL RETURN INDEX, which is Short 5 years CDS of European entities using pure credit exposure and a funded CDS position. It has exposure to iTRAXX credit default swaps.
A short or inverse ETF may be more likely to use CDS, to avoid the expense, operational complexity and risks of locating and shorting physical bonds. Shorting physical bonds can involve a borrow fee and there is also the risk that some bonds cannot be located for borrow, and/or are recalled by the lender of the bonds, which then creates a tracking error problem if the ETF is not short of some index members.
On the other hand, where no CDS exists on a particular company, borrowing and shorting physical bonds may be the only way to get short credit exposure to those names.
These considerations need to be weighed up in the context of the ETF’s objective.
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