(May 25, 2020) – Dustin Lewellyn, Chief Investment Officer of Penserra Capital Management, believes during times of extraordinary volatility in the financial markets that fixed income ETF’s offer greater pricing discovery than individual bonds. “While individual bonds trade in a veiled over-the-counter market,” say Mr. Lewellyn, “fixed-income ETF’s trade on-exchange, like equities. As a result, fixed-income ETF’s reflect real-time pricing since shares of fixed-income ETF’s generally trade more often than their underlying bonds, even in calm markets.”
Case in point–On March 12, 2020, a day of severe market dislocation, the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) traded almost 90,000 times on-exchange. Meanwhile, the fund’s top five holdings traded only 37 times each on average.
Investors look to ETF’s to transfer risk and allocate capital. Fixed-income ETFs, in particular, provide clarity in an otherwise opaque segment of the corporate bond market, a marketplace where fewer than 1% of the more than 21,000 publicly registered corporate bonds trade daily in the OTC market. At a challenging time for bond market liquidity, investors could gain (and sell) exposure by trading ETFs on-exchange.
Valuing Fixed-Income ETF Portfolios in a Volatile Market
There are three ways that investors can value a fixed income ETF portfolio:
- Net Asset Value (NAV)
- The value of the fund’s underlying index
- Market price
All three metrics were hobbled during the early days of the pandemic, leaving fixed-income investors without a consistently reliable metric. ETF investors are accustomed to seeing fixed income ETF NAVs and underlying index values lag the market price in a bond market dislocation. Investors know to rely on market price for valuation, especially for highly liquid ETFs. But during March of 2020, when market volatility was at its highest, many investors were unprepared for market prices of identical funds decoupling.
NAV and the underlying index both rely on bond-pricing services to value each constituent. The services’ models require bond transaction data as inputs. But many bonds trade infrequently during normal times. March of 2020 was not normal times, especially in the corporate markets where spreads widened and NAV and index values lag badly.
At the same time, the market price is not bound to models. It updates with every trade, making it generally well-suited to price discovery, especially for highly liquid funds with active two-way markets (bids and offers) and with the creation/redemption processes intact. The market price is set by the interaction of buyers and sellers, potentially with capital market firms (market makers and authorized participants) stepping in with their bids and offers.
In today’s pandemic environment, market price is the least bad choice of the three. However, during the current market stress, authorized participants’ transaction costs are coming into play, weighing on the market price. As a result, the market price of highly liquid ETFs is not necessarily reflective of the market’s best estimate of the portfolio value.
Price Discovery During a Liquidity Event
A two-sided market, i.e. the presence of both bids and offers, is key to price discovery. If bids disappear in a downdraft, prices will plummet regardless of portfolio value. This dynamic played out when bond market liquidity was under duress during the week of March 9, 2020. Fixed-income ETFs traded at prices below their net asset value (NAV). The NAV is an “estimate” of the fair value of the underlying holdings, based on actual trades of portfolio bonds, estimates derived from trades of bonds from the same issuer or sector, or other market metrics. The ETF price shows what investors are “actually” willing to pay.
Two lessons of note during this period. First, the price of the ETF is likely a more accurate representation of the worth of the basket of bonds at any given point in the day because it represents the collective opinions of buyers and sellers in real time. And second, when volatility spikes, it is anyone’s guess what NAV will become at day’s end, so the discount authorized participants require before they step in to do their work inevitably gets bigger. In other words, these discounts acted as “leading indicators” for underlying bond prices.
Bond ETFs across the industry experienced uncharacteristically large discounts to NAV concurrent with extreme levels of volatility across financial markets. Though discounts of this breadth and magnitude are quite rare, bond ETFs have been tested during prior bouts of volatility and are functioning as they should, given the rapidly evolving macroeconomic, interest rate and credit environment. Importantly, bond ETFs are serving as a vital source of price discovery and liquidity for fixed income investors during a relatively less liquid period in fixed income markets. ETF providers – and analysts who share their perspective – have justified these discounts, claiming they are “price discovery”.
To be clear, large premiums and discounts can’t be safely ignored in all cases, and ETF share prices aren’t always in the right when they don’t match NAV. Sometimes large premiums and discounts signal that the ETF itself trades poorly and is therefore a lousy price-discovery vehicle. Still, the relative illiquidity of the bond market means that bond ETF premiums and discounts cannot be relied upon blindly.
Fixed-Income Price Discovery: ETFs vs. Mutual Funds
Fixed-Income ETFs and mutual funds both seek to offer diversification and daily buying and selling opportunities. However, during periods of high volatility, the ETF structure may offer several advantages, including:
- ETFs provide both primary (creation/redemption at NAV) and secondary/intraday trading. The presence of a liquid secondary market offers price transparency and the ability to liquidate positions often without touching the primary market. Mutual funds can only be redeemed at the market close when the fund manager would have to trade into a depressed primary market to raise enough capital to fulfill any redemption requests.
- The transaction costs (bid/ask spread) of an ETF are borne only by the “transactor,” not passed on to other fund shareholders. Mutual fund investors are not so fortunate; they absorb the cost when other investors exit or enter the fund. For instance, as the seller’s proceeds are valued at NAV, the remaining fund shareholders bear the trading costs of raising the necessary funds to meet the parting client’s redemption.
- Sales of mutual fund shares settle Trade Date + 1 day (T+1). Both primary and secondary ETF trades settle T + 2, as do the underlying bonds. Therefore, mutual funds have a natural liquidity mismatch that managers must account for, which may pose potential issues in a significant selloff.
As a rule, a bond ETF is likely to be an efficient price-discovery vehicle—and therefore indicate that any large premiums and discounts are not a sign of trouble—if the ETF’s shares trade with great frequency and high volume. Because of increased liquidity, fixed-income ETF prices incorporate more real-time information than even their most heavily traded portfolio bonds, demonstrating where there is an actionable price for the entire portfolio. This shows the power of ETFs as price discovery tools, particularly when markets are moving quickly.
 BlackRock, TRACE, March 12, 2020.
 “The coming revolution in credit portfolio trading,” Citigroup, November 2019.
 “Q & A on Fixed Income ETF Liquidity,” State Street Global Advisors, Q1 2020.
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