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.

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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.

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

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.

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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