ETF issuers may struggle to offload Russian securities from emerging market debt ETFs due to ongoing sanctions, market illiquidity and a lack of reliable pricing which could create tracking error risks.
Last month, JP Morgan and Bloomberg – which run the majority of fixed income indices – announced plans to remove Russian bonds from their indices at the next rebalancing date on 31 March following Moscow’s invasion of Ukraine.
As a result of current market conditions, Russian bonds in broad-based emerging market debt indices have been suspended from trading and priced at zero since 7 March. With index providers currently setting Russian sovereign bonds to zero, ETF issuers would need to remove the debt in emerging market bond ETFs in order to continue to match the risk-return characteristics of the underlying index.
As Fitch Ratings said in a research note: “Passively managed ETFs will likely try to exit their Russian positions based on the action the index they follow takes.
“Tracking errors may be increased by differences in fair-value determinations from managers and index providers, with some index providers marking the value of Russian bonds down to, or close to, zero. Market quotes for Russian securities are currently not readily available which may leave funds to determine fair values using models.”
According to data from Bloomberg, Russian bonds typically account for roughly 3-4% of global emerging market debt ETFs, however, this has dropped significantly over the past month as western sanctions on Moscow caused the Russian market to collapse. Europe’s largest emerging market debt ETF, the $8.2bn iShares J.P. Morgan $ EM Bond UCITS ETF (SEMB), currently has a 0.63% – or $51.7m – weighting to Russian bonds.
Offloading the Russian bonds will be a challenge for issuers such as BlackRock, especially considering the US has banned investors from purchasing Russian sovereign bonds on the secondary market issued after 1 March.
“The sharp decline in Russian bond liquidity, the lack of reliable pricing and the restricted access to the Russian market are making it difficult, if not impossible, for emerging market ETFs to sell their holdings, which they would otherwise seek to do,” Fitch said.
In the equity space, emerging market ETFs started trading at high discounts and premiums after index providers such as MSCI made the decision to price all Russian securities at $0. Prior to the Ukraine invasion, Russia accounted for approximately 3.2% of MSCI’s flagship emerging market index meaning the move has forced ETF issuers to write of millions of dollars of investment.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.