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Liquidity risks overhang high-yield ETFs

The United States Federal Reserve Board building is shown in Washington October 28, 2014. REUTERS/Gary Cameron

By Michael Connor

NEW YORK (Reuters) - Shareholders in the AdvisorShares Peritus High Yield ETF who sold in late 2014 are probably not the last to pay up for liquidity risk, a growing hazard for some fixed-income investors bracing for the first Federal Reserve interest rate hike in nearly a decade.

ETFs created in recent years and dealing in often illiquid or thinly traded junk bonds, emerging-markets debt and bank loans are an untested market force that may increase selling pressures in a market turndown, analysts say.

The Peritus fund's holders had a rough ride when its heavy holdings of energy-sector junk bonds were badly stung by falling world oil prices.

The ETF's holders exited in droves, accelerating trading volumes and forcing Peritus (HYLD.P) to sell illiquid securities into declining markets at discounted prices.

Its $1.1 billion of assets nearly halved in five months, and a normally negligible gap between the worth of its holdings and its share price on exchanges swelled to nearly 7.0 percent and worsened returns for sellers.

"There were buyers, though buyers at a very discounted rate, given what was going on," said Noah Hamman, chief executive at AdvisorShares. "I was unhappy about some of the discounts we saw."

Federal Reserve interest rate increases historically exacerbate bond market volatility but this time, investors are worried that hikes may more severely rattle markets, including increasingly risky junk bonds.

Fixed-income high yield ETFs have grown to $37 billion in assets, up from about $10 billion five years ago, according to Lipper, a Thomson Reuters company.

Hedge funds are reportedly readying to profit from a market crisis aggravated by illiquidity, and investors such as Carl Icahn and Bill Gross have raised concerns about liquidity.

The worst mistake investors could make, though, is to try to trade during this type of volatility, especially if they're on a long-term horizon, analysts said.

"The biggest risk is for investors trying to trade through the temporary liquidity mismatches," said fixed income strategist John Gabriel at Morningstar Inc in Chicago.

"If you are not trading, you can sit on the sidelines and just watch."

Wealth advisers should use junk-bond ETFs for holdings that clients will not need for five years, so investors can wait out sell-offs that produce unusual discounts and avoid locking in losses, Gabriel said.

Peritus, now a $350 million fund, was so stressed last year that its normally narrow bid-ask spread widened more than 10 times in early December, according to Thomson Reuters data.

Some of Peritus' energy holdings barely traded in late 2014, making more likely the liquidity-related difficulties that can depress returns for investors obliged to cash out when NAVs are depressed.

Peritus's holdings of Quicksilver Resources Inc 7.0 percent last year traded about a dozen times, while its Talos Production LLC 9.75 percent didn't trade at all, according to Thomson Reuters and FINRA data.

The Peritus portfolio late last year held under 100 securities and bank loans, making it less diversified than other larger ETFs which have had less dramatic liquidity episodes.

The SPDR Barclays High Yield Bond Fund ETF (JNK.P), ordinarily carries a small premium over its net asset value, but traded nearly 1.0 percent below the value of its often thinly traded holdings in May 2013, when bonds sold off fiercely on fears the Fed would end massive bond buying.

Still, outsized discounts in high-yield ETFs in recent years tended to be short-lived, so shareholders should listen to wealth advisers urging patience, according to Matthew Tucker, head of Americas iShares Fixed Income Strategy at BlackRock.

And Richard Bernstein, who runs his own investment firm in New York, said investors should "embrace" the illiquidity, because ETFs trade independently of the underlying asset.

"An ETF investor can exit the investment regardless of whether the underlying market is active," he wrote in late July. "Longer-term investors should probably not worry about short-term disparities between an ETF's price and the underlying NAV because the two tend to roughly equate over time."

(Additional Reporting By Jessica Toonkel in New York; editing by Clive McKeef)