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Aug 26, 2020
News | Business | Markets |Exchange Traded Funds: What we learnt from fixed-income ETFs during the Covid sell-off
While equity exchange traded funds showed no obvious signs of
stress during this year’s sell-off, the picture looked vastly different
in the bond space. In March, some of the biggest corporate bond ETFs’
shares traded at discounts of more than 5 per cent to net asset value
(NAV), having not exceeded discounts of 0.1 per cent in January.
Investors
wishing to raise cash in the teeth of a crisis may well have balked at
the prospect of such deep discounts. But the official explanation
asserts that the problems lie with the underlying fixed-income market
and how it arrives at prices, rather than ETFs, which appear to have
worked as a price discovery tool and a pressure valve for an illiquid
market.
The Investment Association (IA), the UK trade body for
asset managers, draws a stark contrast between the underlying bond
market and bond ETFs in a policy briefing on the subject. It notes that
price discovery for fixed-income securities can be difficult because the
bond market itself is fragmented and not standardised, with no closing
auction period. Bonds are traded over the counter (OTC), or via a
network of dealers and brokers, rather than on an exchange.
As
such, the NAVs for underlying holdings that ETFs (and open-ended bond
funds) refer to are often based on a theoretical bond price that is
“indicative, reasonably estimated and as close as possible to a fair
value”. The theoretical price might not be what a bond actually trades
for, especially in times of stress when valuations are fluctuating
rapidly.
This article was previously published by Investors Chronicle, a title owned by the FT Group.
Research
suggests enormous volumes of bond ETF shares successfully changed hands
in March, with exchanges allowing investors to buy and sell ETF shares
without actually trading bonds. A white paper from Invesco, an ETF
provider, states that US-listed bond ETFs traded a total of $738.8bn on
exchange in March, with just $19.8bn redeemed in the primary bond market
over the period.
This means that $719bn of fixed-income ETF
shares changed hands without a real bond actually being sold — a strong
defence of ETF liquidity. High trading volumes also occurred on the back
of market improvements: on April 9, the day the US Federal Reserve
announced additional stimulus plans, trade in the iShares $ Corporate
Bond Ucits ETF (LQDE) was more than nine times its average daily volume,
according to figures provided to the IA.
Even with investors able
to trade fixed-income ETF shares in bulk, the discounts on show may
have seemed alarming. However, the argument runs that the theoretical
prices achieved in the underlying bond market were stale and
unrealistic, while the prices on ETF shares reflected actual trading
activity.
This view is not limited to ETF cheerleaders. The Bank of England, in its Interim Financial Stability Report
for May, states that prices on bond ETFs “appear to have provided
information about future changes in underlying asset markets, offering
evidence that they incorporated new information more rapidly than the
NAV of assets held within their, and equivalent, funds”.
In its own assessment
the Bank for International Settlements adds: “Compared with the
relative staleness of bond prices and NAVs, ETF prices can be useful
tools for market monitoring and valuable inputs to risk management
models that require up-to-date assessments.”
In other words, ETFs
provided an element of price discovery that was lacking in the
underlying market. It is also “entirely possible that the cash bond
market would have collapsed” had ETFs not been around to relieve the
selling pressure, Invesco argues.
The official argument also deals
with claims that the arbitrage mechanism was found wanting. Normally
arbitrage can prevent ETF share prices from diverging too wildly from
NAVs. If an ETF's shares trade at a discount to NAV, for example, market
participants should be able to buy the shares cheap and separately sell
its constituent parts at a higher price for a risk-free profit.
$719bn
value of ETF fixed-income shares that changed hands in March without a real bond actually being sold
While some of the discounts looked steep at the time, the IA has
argued that there was “no obvious arbitrage opportunity” because market
participants agreed that the ETF prices were based on actual tradeable
bond values.
By contrast, ETF shares trading at premiums or
discounts to NAV can sometimes reflect other developments, such as when a
UK-listed ETF trades at different hours to its underlying market (and
misses some price movements). High transaction costs can also sometimes
lead to slight premiums and discounts.
Invesco has argued that now
is the time to focus on improving how bonds are priced. The asset
manager notes that more over the counter (OTC) markets should have
central reporting of trades and prices, with this data distributed to
market participants with minimal delay. Pricing should also have more
emphasis on traded prices rather than “stale” quotes. The events of
March, they add, should provide “ammunition” for a change.
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