Bond ETFs May Have Shifted Short Market Makers During 2020 Panic

According to the Bank for International Settlements, bond ETFs may have prevented runs on their funds during last year’s market panic by bypassing market makers and the investment banks that serve them.

Exchange-traded funds are designed to closely track the value of their underlying holdings. Yet during the market liquidation caused by Covid in March-April 2020, much of the universe of $ 1.2 billion fixed income ETFs plunged into unprecedented net asset value (NAV) discounts. .

Vanguard’s $ 55 billion Total Bond Market (BND) ETF closed at a 6.2% discount to net asset value on March 12, while iShares Core US Aggregate Bond (AGG) ETF BlackRock’s $ 71 billion ended with a 4.4% haircut on the same day. An array of other junk bond, municipal debt, bank loans, and even US government bond ETFs have also traded at extraordinary discounts to net asset value.

“This isn’t supposed to happen. This disconnect shows that something has gone wrong,” Duncan Lamont, head of research and analysis at Schroders, told the FT at the time.

Haircuts and premiums to net asset value are meant to be eliminated by “authorized participants”, market makers and banks which control the supply of ETF shares in the market.

If an ETF trades at a haircut, the APs are encouraged to buy the undervalued ETF shares in the secondary market and buy them back from the ETF manager, in return receiving the most expensive underlying holdings in a basket. redemption. These holdings can then be sold for a profit.

This process removes the discount by reducing the supply of ETF shares in the secondary market (thereby increasing their price) and increasing the supply of the underlying securities (lowering their price). The system works in reverse if an ETF trades at a premium to the NAV, with the APs buying the underlying holdings and trading them with the sponsor for newly created ETF stocks.

Yet this arbitrage mechanism clearly collapsed for bond ETFs during this period in 2020.

A Basel-based BIS document suggests this was due to ETF sponsors deliberately giving PAs lower-grade bonds in order to dissuade them from repurchasing shares of ETFs.

Unlike equity ETFs, where the build and redeem baskets that ETF sponsors trade with APs are essentially the same as the underlying holdings of the fund, bond baskets vary wildly from the intrinsic portfolio.

According to the BIS, these start-and-buy baskets can only hold 3% of the ETF’s bonds, in part because the relatively high minimum trading size of the bonds means that it is impractical to hand an AP a tiny shards of hundreds, even thousands. of bonds.

If ETF sponsors wish to discourage buybacks during market fluctuations, they can potentially fill the buyback baskets with lower quality bonds, such as those that are high risk or illiquid.

Not only would this discourage repurchases by APs, it could also ease the nervousness of end investors in the ETF, potentially deterring them from selling.

“The lower-grade bonds that APs get after buying back ETF shares would reassure non-active investors that their shares are now backed by higher-middle-grade holdings. This would discourage further executions and lead to discounts on the ETF during execution episodes, ”said Karamfil Todorov, BIS economist and author of the article.

Todorov thinks that’s exactly what happened last year. “Such a stabilization mechanism was undoubtedly in place during the March-April 2020 episode when certain ETFs were trading at a discount while buying back baskets that were more illiquid than the holdings,” he added.

The analysis undermines the widely held view that only the US Federal Reserve’s extraordinary stimulus package – which included the mass purchase of bond ETFs – prevented catastrophic runs for fixed-income ETFs, which would have been forced to sell short-term illiquid bonds, potentially for sale at a discount. prices.

“The decoupling of baskets from farms can be a shock absorber in times of volatility,” Todorov said. “The partial convertibility that stems from decoupling means ETFs could be a stabilizing force during races and prevent fire sales.

“This mechanism is possible due to the predominantly in-kind nature of ETF buybacks, where shares are exchanged for securities. It is not available for other investment vehicles with cash redemptions such as mutual funds.

However, Todorov warned that there was a downside to ETF sponsors handing out shoddy credits to hapless PAs.

“Such a strategy can backfire in the long run because it can damage the reputation of ETFs. If investors perceive an ETF as only buying low quality bonds in times of crisis, they can pull out of the ETF altogether, ”he said.

Peter Chatwell, head of multi-asset strategy at Mizuho, ​​saw the practice as “a good cutout” in times of stress. Nonetheless, he too argued that there was a potential downside.

“It will be negative for the ETF,” Chatwell said. “This will increase its tracking error against the underlying securities. . . This is not a desirable outcome.

However, John Hollyer, global head of fixed income at Vanguard, disputed the findings of the paper, saying that “the presence of haircuts on bond ETFs during this period was mainly a reflection of the higher costs and the uncertainty in the bond markets and was not an obstacle to the arbitrage mechanism underlying the creation and redemption ”.

Another large fixed-income ETF manager, who spoke on condition of anonymity, said that he “provided in-kind redemptions in accordance with the usual in-creation / redemption process which offered assets with a profile similar to the relevant ETF. We did not offer low quality illiquid bond baskets as this would have resulted in a tracking error ”.

A senior official at a major market maker, who also asked not to be named, said that while the BIS analysis was “a reasonable theory and the logical steps it takes make sense,” it “does not correspond to our experience”.

He said his company had continued to buy back fixed income ETFs throughout the March-April crisis and had consistently been offered representative baskets of securities that neither disadvantaged investors who remained in the market. funds nor those who chose to redeem.

He said the reason the selling activity did not close the funds discount to NAV quickly was that the lack of liquidity in some of the underlying bonds meant that their market prices had become stale and unreliable.

“I think the conclusion is wrong. There is a relational aspect here. If we were treated unfairly, our reaction would be that we had to create much larger markets. Investors would pay a larger spread to enter and exit, ”he added.