The report, entitled The recent distress in corporate bond markets: cues from ETFs, analysed the impact that mutual funds’ large outflows and secondary market yield spreads to government securities has had on European and US corporate bond ETFs.
In mid-March, a large volume of corporate bond ETF discounts dropped significantly below the values of their underlying NAV driven by high market volatility, reduced risk-taking by dealers and investors' reaction policy decisions.
According to the BIS, the discounts highlight how NAVs are slower to incorporate information than ETF prices amid a relative illiquid corporate bond market.
Furthermore, the BIS said the NAV discounts were a reflection of liquidity providers offering less support to the corporate bond market which limited the arbitraging of NAV discounts. Additionally, money market funds saw large inflows after the US federal banking regulators launched the Money Market Mutual Fund Liquidity Facility.
These events have brought to light how quickly ETF prices react to market developments compared to the prices of the underlying bonds – even more so during periods of market stress. Therefore, ETF prices are likely to be more accurate than stale bond benchmarks at risk management modelling and underpinning regulatory capital calculations.
Corporate bond liquidity has struggled to recover ever since the Global Financial Crisis in 2008 which impacted all asset classes, however, most have rebounded. The BIS says the economic reaction to the coronavirus outbreak has provided further evidence that corporate bond liquidity remains fragile.
Investors were suffering heavy losses by mid-March and mutual funds were focusing on high yield credit which also came under pressure as outflows started accumulating. As a result, there were a number of cases where mutual funds had to be gated, according to the bank.
In tandem with mutual funds suffering outflows, investment grade corporate bond ETFs and high yield bond ETFs in the US and Europe were recording discounts in excess of 5%. However, US investment grade ETFs had the most pronounced dislocations, most likely because they were the product of choice being oversold for cash by investors. High yield bond ETFs were most heavily impacted in Europe following the lack of support from the European Central Bank’s corporate purchase programme.
On 12 March, corporate bond ETFs experienced a spike in NAV discounts, the same day the implied volatility index in the US, VIX, a common gauge of market stress, reached its then-highest value since the GFC. Three days later, the Federal Reserve announced its purchasing programme of US Treasury and mortgage-backed securities which likely cleared the risk-taking capacity in dealers’ balance sheets.
There was still a large volume of flows from ETFs to money market funds which likely resulted in NAV discounts to spike again on 19 March.
Sirio Aramonte, senior economist at the BIS and co-author of the report, said the NAV discounts reflected investors rotating out of short-duration investment grade ETFs and into money market funds just as the Federal Reserve and the US Treasury established a lending facility to help money market funds avoid selling assets at deep discounts to meet redemptions.
He explained this is shown by investment grade ETFs with durations under three years recorded larger NAV discounts than average which suggests stronger selling pressure. Secondly, investment grade corporate bond mutual funds also experienced outflows while money market funds accelerated further.
The BIS highlighted how the NAV for mutual funds is calculated once a day whereas ETFs trade continuously which is enabled by intermediaries providing liquidity.
Therefore, ETFs incorporate information in a more timely manner than the underlying bonds and surprising ETF prices usually results in unexpected NAVs but not the other way around, the report added.
NAV prices become even slower to respond to ETF prices during volatile periods and if both ETFs and the underlying bonds were to incorporate new information quickly, neither price return would be useful at predicting future price returns.
ETF prices are a useful tool to monitor the market and valuable inputs to risk management models that require up-to-date assessments such as trading book risk models.
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