Bond ETFs survived their first big crisis
Sam Huszczo had long been a skeptic. ETFs, already wildly popular among equity investors, were emerging as a cheaper, easier way to build a fixed-income portfolio than investing in a mutual fund. But after a decade-long bull market, no one could be sure how the new products would perform in a downturn. Would they exacerbate turmoil in their underlying markets?
Finally, near the end of 2018, the founder of SGH Wealth Management in Southfield, Michigan, decided to give them a try, investing about 27% of the firm’s assets in the funds. Throughout 2019, things seemed to be working well, Huszczo says. Then the coronavirus became a global pandemic, plunging stock and bond markets into a downturn.
Huszczo, like so many other money managers who overcame trepidations and piled into the new market, could only watch as the record volatility that plagued U.S. bond markets in March led to share prices of bond ETFs trading at deep discounts to the value of their underlying assets. On March 23 the Federal Reserve said it would buy corporate debt and eligible ETFs and then expanded the program weeks later to high-yielding securities to keep credit flowing.
“Everything was in a free fall until the Fed stepped in,” says Huszczo, who turns 39 in July. “No one likes to see their bond portfolio go down like that.”
By early May, with that big assist from the U.S. central bank, the consensus was that fixed-income ETFs had — for the most part — passed their first big test. But it was a roller-coaster ride along the way.
After years of sluggish growth, ETFs that track corporate or government debt last year took in more than $150 billion in the U.S., the most on record and just short of the sum attracted by equity ETFs. That’s boosted total assets to about $858 billion, or roughly 21% of U.S. ETF assets, data compiled by Bloomberg Intelligence show.
Critics and regulators have long voiced concerns that fixed-income ETFs, because they’re much more liquid than their underlying assets, would exacerbate price declines when investors scramble to redeem their holdings during periods of market stress. Mohamed El-Erian of Allianz and Scott Minerd at Guggenheim Partners are among veteran investors who have suggested ETFs could act as a destabilizing force in illiquid credit markets where they have an outsize trading share.
When U.S. stocks fell more than 30% in March during the worst sell-off in history, bond ETFs showed signs of liquidity stress. Some of the hardest-hit were the Vanguard Total Bond Market ETF (BND) and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
In one notable example, on March 12, Vanguard’s BND was down 3.8% year-to-date, while its mutual fund counterpart — the Vanguard Total Bond Market Index Fund — was up 2.7%. The prices have since reunited, with both funds up about 3.7% so far this year as of May 11.
Dorian Garay, a New York-based portfolio manager for NN Investment Partners, says that such a divergence in prices during a period of stress limits the value of fixed-income ETFs for some investors. “The potential problems of investing in ETFs are related to risk management, as you cannot actively manage your risk exposures,” he says.
Investors were still able to trade through the market turmoil, just not at the prices they might have hoped for. “If investors wanted that liquidity, they basically had to pay for it,” says Ryan Sullivan, senior vice president of Brown Brothers Harriman’s global ETF services. “They were able to access it. It certainly was not an ideal trade, but all things equal, the funds held up.”
In the underlying markets that the ETFs track, trading essentially froze in many debt securities. That spooked the specialized traders — known as authorized participants — who normally keep a fund’s price aligned with its net asset value. Typically, those market makers will buy shares of a falling ETF to redeem in return for the underlying bonds, which they then can sell. That process reduces the number of shares outstanding and keeps the ETF in lockstep with its holdings. But in March, appetite for that arbitrage trade soured as those traders became wary of getting stuck with hard-to-unload bonds.
“They’re not doing this out of the goodness of their hearts,” David Perlman, an ETF strategist at UBS Global Wealth Management, says about the authorized participants. “They don’t jump in until they think they can execute the redemption and make a profit from doing so.”
As the individual securities stopped trading, fixed-income ETFs served as a price discovery tool instead.
“ETFs were actually showing the true value of where fixed income was priced real time,” says Will McGough, CIO of retirement strategies at Stadion Money Management in Watkinsville, Georgia. “Because the bonds don’t price themselves — they only price when they trade — they [ETFs] were effectively the supermarket for pricing bonds for a week or two.”
There’s debate within the industry over how to accurately value fixed-income ETFs and their holdings during such a period of stress: Is the true price the net asset value of the underlying securities or the cost at which you can execute trades?
Huszczo compares it to real estate websites that calculate “what our house is worth based off algorithms and comparables.” In reality, he says, “nobody believes that is the actual number. The actual number is just, ‘What is some other person willing to pay for this?’ ”
Opinions about the performance of debt ETFs come down to how investors understand the structure, explains Sue Thompson, who leads distribution of State Street’s SPDR ETFs in the Americas. “The dislocations happened first in the underlying market,” she says. “If there were not disruptions in the underlying markets, there would have been no disruptions in the ETFs, period,” she says.
Few market participants expect a slowdown in the momentum fixed-income ETFs have developed. The perks simply outweigh the dangers, they say.
For instance, ETFs allow asset managers faced with client redemptions that once would have forced them to sell their most liquid bonds to instead sell a slice of a group of bonds in the form of ETF shares. Their portfolio won’t look drastically different afterward. And ETFs, because they’re so liquid, can be used to park cash until it’s needed to purchase new bonds.
These funds can also make portfolio trading more efficient. When an asset manager wants to offload a bunch of bonds, intermediaries are willing to purchase them as a whole package because they can turn around and sell the inventory into ETFs. Last year, Wall Street’s bond desks executed at least $88 billion worth of such trades, according to an analysis by Morgan Stanley. That’s compared with virtually none two years ago.
“This may be — while a large blip on the radar — a blip on the radar,” Sullivan says. “I don’t think anyone is running for the hills from ETFs.”
Huszczo certainly isn’t. “We’re not going to rush to judgment over a couple of days. Investing for our purposes is long term,” he says. “ETFs did what we expected them to do.”