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Voices: What caused a junk-muni ETF to go into free-fall?

The industry’s two largest ETFs focused on speculative-grade debt suffered a combined $1.92 billion in outflows in May.
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No one seems to know quite what to make of the stunning price drop in the largest high-yield municipal-bond ETF.

The VanEck Vectors High Yield Municipal Index (HYD), with $3.6 billion in assets, was the picture of tranquility for much of the past three years. From the start of 2017 through February, its share price traded in a range of less than $7, starting at $59.26 and climbing to as high as $66.14 on Feb. 26.

Then something snapped suddenly. It fell 1% on March 6. Then 5% on March 9. Then 3.4% and 2.3% on March 10 and 11 before plunging a whopping 15.6% on March 12 during the worst stock rout since Black Monday in 1987. Within the span of about two weeks, it had dropped from an all-time high to an all-time low. It was such a violent sell-off that it triggered the SEC’s “alternative uptick rule,” which restricts short selling from further driving down the price of a stock that has dropped more than 10% from the previous day’s close. The moves started days before the rest of the market cracked.

Because the ETF reacted so fast, its price fell much further than what the bonds it owns would indicate. I noted this anomaly in a column on March 10, but the difference only reached greater extremes since then. By March 12, HYD tumbled to a record 19% below its net-asset value, which Bloomberg News’ Katherine Greifeld calculated as the single-biggest discount in the entire $4.4 trillion ETF market.

So, what’s going on here? I have a hunch that it centers on a combination of risks unique to the coronavirus pandemic, unique to high-yield municipal bonds and unique to the ETF structure.

First, about the ETF structure. The unprecedented volatility last week in everything from risky corporate bonds to U.S. Treasurys has caused market-makers to step back in an effort to avoid getting caught in a bad position. In ETFs, these are known as authorized participants, as Greifeld explains:

“Rampant turbulence across bonds markets is souring appetite for the arbitrage opportunity that normally keeps ETF prices in lockstep with a fund’s value. Normally, middlemen known as authorized participants will buy shares of a falling ETF in order to exchange for the underlying bonds with the fund’s issuer. That market maker will then sell those securities to pocket a virtually risk-free profit. The ETF’s price usually snaps back to the fund’s net-asset value as the supply of ETF shares is reduced.

But fear over the coronavirus’s economic fallout has unleashed historical volatility in fixed income, making it harder to unload the underlying bonds. As a result, the ETFs are trading at persistent discounts as thin liquidity sidelines market makers.”

Without question, that dynamic explains part of HYD’s huge discount. But it’s also crucial to understand the idiosyncratic nature of the high-yield muni market.

With some notable exceptions like tobacco bonds, speculative-grade munis just don’t trade very often in the sort of size that would interest institutional buyers. That’s because no two issuers are quite the same. For example, the part of the Bloomberg Barclays index of high-yield munis with the most securities is the hospital sector. Within the double-B rated hospital segment, some of the bigger borrowers include Loma Linda University Medical Center in California, OU Medicine in Oklahoma and Albert Einstein Healthcare Network in Pennsylvania. It would be dangerous to simply assume the underlying credit fundamentals of each of those are interchangeable. And those are some of the market’s top issuers.

This brings me to the final point: coronavirus-specific risks. Yes, junk-rated munis tied to airlines plunged over the past week. But there were some even more drastic moves in senior-living facilities. Here’s Bloomberg News’s Amanda Albright:

Unrated debt issued for organizations connected to the Trousdale Foundation, which runs elderly-care facilities, changed hands at about 53 cents on the dollar on Friday, after trading at 113 cents on the dollar in February. And a Tennessee deal sold in late 2019 for a retirement facility also traded below par on Friday.

Just for good measure, I’ll bring up two deals facilitated by the infamous Capital Trust Agency in Florida.

Unrated debt issued for Tapestry Senior Living traded as low as 38.5 cents on the dollar on March 6, down from 100 cents as recently as Dec. 5. The homepage for each of its locations includes a banner titled “COVID-19 UPDATE” that details its no-visitation policy because of the outbreak. “Thank you for assisting us in keeping everyone safe and healthy and thank you in advance for your understanding of our need to operate with an abundance of caution,” the website reads.

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Similarly, unrated securities issued for Tuscan Gardens of Palm Coast plunged on March 6 to 57.5 cents on the dollar from 98 cents on Jan. 7. These are fire-sale prices.

Based on publicly available holdings data compiled by Bloomberg, HYD owns each of these bonds. And in the case of the Trousdale Foundation, Tapestry Senior Living and Tuscan Gardens debt, the ETF’s position declined by exactly the same amount as the deeply discounted March 6 trades.

Here’s the narrative that forms when you put all this together: In the first week of March, with HYD at the widest discount since December 2016, at least one middleman stepped in to buy shares and exchange them for the underlying bonds. That is, after all, what they do. But that market-maker couldn’t find anyone to buy the debt at a reasonable price because of the idiosyncratic nature of high-yield munis. Who’s to say which of the Florida assisted-living facilities will best address the coronavirus outbreak? So the securities were offloaded at steep cuts from where they had been previously valued. That sort of painful experience could have scared away all authorized participants, allowing HYD to free-fall without anyone to catch it.

Perhaps the most ominous part of all is that HYD could be a harbinger of what’s to come for high-yield muni mutual funds, which experienced a record $1.7 billion of withdrawals in the span of a week. “The price of a fixed-income ETF is likely a more reliable indicator of the value of its underlying bonds than the net asset value, in our view, with the latter often stale and based on estimates,” Bloomberg Intelligence’s Athanasios Psarofagis and Eric Balchunas wrote in a report Friday. Indeed, it took a bit longer, but the price of the $21.9 billion Nuveen High Yield Municipal Bond Fund has also tumbled along with its benchmark.

It’s scary enough to attempt to catch a falling knife the first time. Now imagine doing so after already suffering a deep cut. That, in a nutshell, is the state of the high-yield muni market.

Bloomberg News