Analysis of primary market flows relative to share turnover suggests investment vehicle is still functioning as intended
Over the past few weeks, large gaps have developed between the value of bond ETFs and that of their underlying holdings. That includes the iShares iBoxx $ Investment Grade Corporate Bond ETF, the largest of its kind, which has shown both its largest discount and its largest premium to net asset value in 11 years.
Those discrepancies have reopened questions about the bond ETF structure, particularly whether it represents a systemic risk reminiscent of the 2008 Global Financial Crisis, as trading in liquid ETFs could be severely crippled by dramatic selloffs in the underlying illiquid bonds. But Wall Street Journal reporter Jon Sindreu argues that the nightmare scenario hasn’t played out yet.
“While the iShares ETF and its sister junk-bond product recently experienced their largest outflows on record, activity in the ‘primary’ market … hasn’t been abnormally elevated relative to the high turnover of the ETFs’ shares on stock exchanges,” Sindreu said.
Drawing from FactSet data, he analyzed the weekly primary market flows of the iShares investment-grade ETF. He found that flows as a percentage of share turnover has not exceeded 200% since the COVID-19 selloff started, and has mostly been constrained below 100% in the selloff’s latter stages; by comparison, that ratio spiked past 300% late in June 2019.
In 2008, investors fled complex credit derivatives even after some underlying mortgage-backed securities mitigated the impact. The situation today is much different, Sindreu said, citing analysts from French bank Société Générale who said ETF prices have become “the effective benchmark prices of the underlying market.”
Some ETF prices, he argued, may now be more “real” than the markets they track, similar to how oil futures contracts have supplanted spot transactions as a yardstick for prices of crude. Today’s globalized, highly complex financial markets may have made top-down macroeconomic information more germane than bottom-up facts, which means discounts to NAV of bond ETFs may reflect a need for bond prices to catch up.
“During the coronavirus selloff in particular, traders have often been clueless about the worth of individual issues, while still having strong views about the economic shock,” he said, noting that such views have been primarily expressed through ETFs and partly through index-based credit-default swaps.
Even junk-bond ETFs, he added, are still functioning properly, hinting at a breaking point that’s higher than some have feared. The U.S. Federal Reserve’s plans to buy shares in investment-grade corporate bond ETFs along with the underlying bonds as part of its stimulus policies offer another point of reassurance.