|27 March, 2020

Bond ETF turmoil exposes credit’s faulty wiring

Total global assets in bond ETFs stood at more than $1 trillion at year end after net flows ballooned over the past decade

NYSE-AMEX Options floor trader Luis from TradeMas Inc.works in an off-site trading office built when the New York Stock Exchange (NYSE) closed, due to the outbreak of the coronavirus disease (COVID-19), in the Brooklyn borough of New York City, U.S., March 26, 2020.

NYSE-AMEX Options floor trader Luis from TradeMas Inc.works in an off-site trading office built when the New York Stock Exchange (NYSE) closed, due to the outbreak of the coronavirus disease (COVID-19), in the Brooklyn borough of New York City, U.S., March 26, 2020.

REUTERS/Brendan McDermid

NEW YORK - Ignorance may be bliss sometimes, but not in the bond market. During this month’s financial carnage, some fixed-income exchange-traded funds traded at a significant discount to the value of their underlying assets – by 5% at one point, for one that BlackRock’s  iShares division manages, the biggest gap since 2008. But it’s not an ETF problem.

Total global assets in bond ETFs stood at more than $1 trillion at year end after net flows ballooned over the past decade. As tradable shares, they can be liquid. The vast majority of corporate bonds, meanwhile, rarely change hands, creating a mismatch between the fund and its underlying securities. It also means these ETFs can be a better indicator of shifting market sentiment.

Trading corporate debt has a couple of complicating factors. First, some of the biggest debt issuers have hundreds of bonds outstanding with a variety of rates and features, yet only a few trade regularly. Most companies only have one tradable stock.

There’s also a lack of transparency. Much debt trading still involves working with market makers, who themselves normally have limited presale data. Only around 30% of investment-grade U.S. corporate debt was traded electronically in February, according to Greenwich Associates; it was less than half that for U.S. high yield paper.

True, industry regulators have a system for disclosing trade details. And firms like MarketAxess and BondCliQ are making the market less opaque by either reducing the role of middlemen or providing better data. But many bond investors still have a hard time figuring out if they’re getting the best price.

New emergency programs allow the Federal Reserve to buy corporate debt and ETFs, an announcement which by itself probably helped support prices. If the Fed does jump in, that may also limit significant future dislocations between ETFs and their underlying bonds – even if the Fed doesn’t actually buy tons of corporate debt.

Transparency is not such an easy fix. The sudden presence of a buyer who is also a watchdog may prompt market makers to up their game for now, as much as they can. After all, a player using public funds ought to ensure it’s getting a fair price. Longer-term fixes require more innovation, perhaps even regulation. The Fed’s new role may be just the prod the market needs.

CONTEXT NEWS

- Bond exchange-traded funds, including BlackRock’s iShares iBoxx Investment Grade Corporate Bond ETF and the Vanguard Total Bond Market Index Fund ETF, have recently traded at significant discounts to their net asset values. The BlackRock ETF traded at a 5% discount at one point – the widest since 2008.

- During the week of March 16, BlackRock raised the fees market makers must pay to redeem shares of its iShares Short Maturity Bond ETF, causing the ETF share price to fall 6.2% on March 19; it has since risen around 5%. Vanguard also introduced fees for cash redemptions for its Vanguard Total International Bond ETF.

- In the week ending March 18, taxable bond ETFs had $13.2 billion in net outflows, according to Reuters.

(Editing by Antony Currie and Amanda Gomez) ((anna.szymanski@thomsonreuters.com; Reuters Messaging: anna.szymanski.thomsonreuters.com@reuters.net))

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