The financial storm unleashed by coronavirus has ripped bond exchange traded funds from their moorings, providing the first big test of a market that has grown dramatically in recent years.
Investors have flocked into fixed-income ETFs, which sell shares underpinned by corporate debt to give simple, speedy ways to bet on a market that can otherwise be tricky to access and trade.
But a deep sell-off earlier this month created big dislocations between the prices of bond ETFs and the value of the bonds behind them. These discounts became so wide that some predicted investors would lose faith in the fund structure altogether, and dump their holdings — further damaging debt market conditions.
Then the US Federal Reserve stepped in. On Monday, the central bank announced it would begin to buy corporate debt to quell the crisis — including bond ETFs. And it picked BlackRock, one of the biggest providers in the $1.1tn market, to manage the purchases. ETF prices surged.
So what went wrong?
Corporate bond prices tumbled in early March, but fixed income ETFs fell even further, resulting in extraordinary discrepancies between the price of ETFs and their assets.
For example, the price of BlackRock’s $35bn-in-assets investment grade bond ETF — known by its ticker LQD — has historically bounced around within 50 cents per share of its “net asset value”, or the value of the bonds it holds. But recently it slid to more than $6 per share below its NAV, the biggest discount since the depths of the 2008 financial crisis. A host of other ETFs that track junk bonds, municipal debt, bank loans and even US government bonds have also traded at extraordinary discounts to their NAVs.
As markets rebounded on Monday following the Fed’s move, the price of LQD soared to more than $5 per share above its NAV, the biggest premium since the ETF’s creation in 2002. Others mirrored the move.
Why are big swings a problem?
ETFs are designed to mimic the markets they claim to track. Some analysts and investors argue that the product is fundamentally flawed if it fails at that basic task, and no longer accurately reflects the movements of the underlying securities.
The biggest fear is that this could cause investors to lose trust in bond ETFs entirely, pouring fuel on the fire of a sell-off in the underlying market.
What stops this from happening?
When ETF prices drift from the value of the underlying holdings, market makers — known as “authorised participants” in the industry jargon — normally swoop in to close the gap by creating or redeeming shares in the ETF.
Creation is when an AP buys bonds and hands them over to the ETF provider in exchange for a set amount of shares. Redemption is when it gives back shares in exchange for the bonds.
In theory, the price of the fund and the value of the debt it holds should be the same. So, if the ETF value drops below the value of the underlying bonds, APs can buy the cheaper ETF shares and exchange them for the underlying bonds.
When conditions are reversed, they can buy the cheaper underlying bonds and turn them into ETF shares. Most of the time, this arbitrage keeps an ETF’s price and its NAV in line.
So when prices diverge, which one is correct?
Fund proponents say that despite gaps displayed on trading screens, the price of the ETF is not higher or lower than the true value of the debt. Instead, the ETFs reflect the real value, and it is the bond market that is dysfunctional.
“In our view, this is not an ETF dynamic occurring right now but a bond market dynamic, and the ETF is showing you in real time how conditions are evolving,” argued Steve Laipply, US head of BlackRock’s iShares fixed income ETFs.
APs say that if they were to redeem shares and try to sell the bonds in the market, the price they would get would be the same as the ETF. They argue that the prices reflected by bond indices are inaccurate because they have become stale, reflecting assets that have seen little or no trading activity. “It’s a market structure problem,” said Reggie Browne, a principal at GTS, a market maker.
Investors complain that the ease of trading debt has drastically deteriorated in the midst of rapid outflows from bond funds. Instead, investors have used ETFs to conduct broad trading against the index, making them a better gauge of the “true” market.
What happens next?
The Fed will buy investment-grade corporate bonds with a maturity of five years or less. The central bank’s decision to include ETFs in its purchases has been taken as a nod to the products’ widespread use among fund managers. It has also been seen as a potential backdoor for the Fed to influence longer dated corporate debt held by the ETFs — extending its sway over borrowing costs.
Some investors say the medicine is already working. LQD has taken inflows of more than $1bn each day this week, according to Bloomberg data, while its price has rebounded.
ETFs are “likely moving faster than corporate bonds,” said Viktor Hjort, global head of credit strategy at BNP Paribas. “I think we will start to see some stability emerge.”