The massive inflows into US high-yield bond ETFs could end badly if a "significant dislocation" were to hit markets, warns UBS.
UBS head of fixed income Anne Anderson said the high-yield ETF market has not been heavily tested in a "significant market dislocation".
While the more 'traditional' mutual fund high-yield market has been tested (for example, during the 'taper tantrum' of 2013), the ETF market has yet to face the same challenge, Ms Anderson said.
"The underlying instruments are generally liquid, but in a dislocation (say, the market thought we were headed into a recession) defaults would go up," she said.
"That would not be positive for the performance of high-yield and you would start seeing people coming away from the asset sector."
Ms Anderson said she knows from experience that in poor market circumstances previously liquid assets can quickly freeze up – particularly when large quantities are being traded.
"Bank balance sheets can only provide you with so much liquidity around the world. So if you had to sell $100 million as opposed to a more 'nimble' $10 million that makes it tougher," she said.
Some of the high-yield ETFs being traded have gotten "so big" that investors need to factor in liquidity risks, Ms Anderson said.
"Regulators are also considering this fact, because sometimes there is no bid in really terrible circumstances," she said.
She added that high-yield ETFs face the same liquidity challenges of mutual fund in the sector.
Ms Anderson gave the example of an institutional investor trying to sell $100 million of high-yield debt when the issue size was only $300 million.
"That's an extreme example, but that's when liquidity is tested. Especially when there are no natural buyers," Ms Anderson said.
"It forces the price downward more quickly or more sharply than would normally be the case because there is no market clearing level," she said.
While there is no high-yield bond market to speak of in Australia, Ms Anderson said hybrid securities are a close equivalent – but they are exchange-traded and not highly liquid.
Standard & Poor's downgraded the credit ratings of the Australian major banks' hybrids last month.
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