Bond ETFs Shrug Off COVID Woes

Bond ETFs were stress tested in March’s market meltdown. Whereas discounts to net asset value (NAV) hadn’t gone above 0.1% by January, in some instances they shot beyond 6% in the COVID-19 induced turmoil in early spring.

The reason for this blowout—greater than that which occurred with their equity peers—is that while ETFs are very liquid, many of their underlying bond holdings are not. In such cases, daily prices at best are proxies (marked to market); and in the worst case, the price for the last trade.

There is therefore more of a chance that bond ETF prices will diverge from those of their less liquid underlying securities. This in turn begs the question: while this relationship means that ETFs can aid in bond price discovery, could it be a problem at times of extreme market stress? And, lastly, how have investors responded in the wake of these events?

Bunfight at the ETF Coral

All of which is benefitting at least one group—finance PhD students, who are getting a whole load of material. There’s been a veritable bunfight going on in the academic and central bank literature. It’s an ill wind, after all.

The Bank of International Settlements noted that these discounts reflected a number of factors: because of the relative illiquidity of corporate bond markets, NAVs incorporate information more slowly than prices, making deviations more likely during such times; dealers provided less support to corporate bond liquidity, potentially limiting the arbitraging of NAV discounts; and that there had been a possible rebalancing from short-duration investment ETFs to money market funds during March, contributing to the stress. All of which could be viewed as red lights for investors.

Another paper warns that “higher ETF ownership of investment-grade corporate bonds can reduce the ability of investors to diversify liquidity risk [which] may result in facing higher transaction costs and significant impact on bond returns, and even, not being able to trade during stress times”.

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