Abnormal discrepancies between vehicles and underlying bonds shake investors' faith
Last year, fixed-income ETFs emerged as a darling among investors as they sought a measure of safety in their portfolios. But as the products trade out of phase with their underlying assets, an old debate on liquidity risk has been reignited between their critics and advocates.
As shocks from the global coronavirus pandemic rippled through the markets in recent days, bond ETFs offered by BlackRock, Vanguard, and other firms traded at historic discounts relative to their underlying bonds, reported the Wall Street Journal.
On a typical trading day, the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) offered by BlackRock trades within a fraction of a percent of the bonds it’s made to track. But late last week, that discount exceeded 5% as it closed down; that discrepancy exceeded 1.5% at the close of each day of the past week.
Meanwhile, the Vanguard Total Bond Market ETF (BND) —one of the largest bond ETFs in the world, traded at a discount to net asset value of 6.2% earlier this month, the biggest gap in its history.
Those gaps have provided ammunition for critics of the bond ETF structure, who have long contended that a mismatch in liquidity between the products and the bonds they’re supposed to track would cause the ETFs to fail during a protracted rout. A failure in the funds, they say, raises doubts over whether investors actually get a fair price.
That failure is more likely to happen in choppy markets, when bank intermediaries and other market-makers who buy baskets of fixed-income instruments to exchange for shares of ETFs can’t profit easily. Ordinarily, those market participants can step in comfortably, which allows ETF prices to stay in check with their underlying investments.
But as investors rushed to sell assets and unwind trades, there’s been a collapse in the correlations between financial instruments, and parts of the bond market that once offered safety have turned treacherous as liquidity vanished. As the liquidity vanished, spreads between the bonds and ETFs that offer exposure to them increased.
“That spread is an indication of the increased difficulty of executing what should be a risk-free arbitrage,” said Greenwich Associates’ Ken Monahan, who focuses on market structure and technology.
Nevertheless, advocates counter that the ability to access less-liquid securities within a tradeable package makes ETFs critical when news travels too fast for trading in other markets to keep up. And ETF traders contend that the market is fair so long as there’s a multitude of buyers and sellers on exchanges.
“You’re getting a lot of information—real-time information—being transmitted by the ETF about conditions in the bond markets,” Samara Cohen, BlackRock’s co-head of iShares markets and investments, told the Journal. “Markets and bonds aren’t trading fast enough to validate or invalidate the information.”
Vanguard’s head of ETF product management Rich Powers pointed to a surge in the average daily dollar volume of fixed-income ETFs trading on the New York Stock Exchange during the first four days of last week — it was five times higher than the previous year’s average — as evidence that ETFs are seen as the vehicle for price discovery.
“It’s not to say it’s the perfect price,” he said. “There is no perfect price in the bond market.”