The liquidity mismatch between fixed-income exchange-traded funds and the bond markets is on display again.
Some of the biggest credit ETFs are trading at sky-high premiums to the value of their underlying assets after the Federal Reserve said it will buy high-grade corporate bonds and ETFs. The US$35 billion iShares iBoxx $ Investment Grade Corporate Bond fund, ticker LQD, closed at a 5 per cent premium to its net asset value on Wednesday -- the biggest divergence on record. Last week, it slumped to a discount of 5 per cent relative to the presumptive value of its bond holdings, the most since 2008.
LQD’s rapid swing from discount to premium highlights the differences in liquidity between debt ETFs -- which trade on exchanges and behave like stocks -- and the bonds themselves. Last week, when fixed-income markets were all but frozen amid a global cash crunch, models that calculate net-asset value were slower to reflect the falling prices given that not every bond was trading, according to UBS Global Wealth Management’s David Perlman. Now -- as inflows flood credit ETFs in anticipation of the Fed’s purchases and the funds rally -- the reverse is true.
“Things have gotten better and the bonds are rallying, but not every bond is trading and those models still have to adjust their prices,” said Perlman, an ETF strategist. “So it’s still the same issue where the NAVs going to be slower to reflect where the bonds can be traded.”
The U.S. central bank said Monday that it would create a Secondary Market Corporate Credit Facility, one of several new measures aimed at cushioning the economic blow from the coronavirus. The terms of the facility allow for the purchase of up to 10 per cent of an issuer’s outstanding bonds and up to 20 per cent of the assets of any ETF “whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds,” a primer accompanying the Fed action said.
As a result, LQD has rallied over 14 per cent this week and is on track for a record week of inflows. The risk-on tone has boosted junk bond funds -- which don’t meet the Fed’s purchasing criteria -- as well, with the US$14.4 billion iShares iBoxx High Yield Corporate Bond ETF on track for a 9.2 per cent gain this week. The ETF closed at a 2.6 per cent premium to its net-asset value on Wednesday, the biggest gap since 2011.
Mizuho International Plc’s Peter Chatwell expects the premiums will ease as corporations take advantage of attractive borrowing costs to issue more debt, after being sidelined by volatility over the past few weeks. That supply should help offset demand and restore order between the ETFs and the underlying bond markets.
“LQD had strong inflows, but the underlying bonds have not been able to appreciate in value with the same magnitude, highlighting the liquidity mismatch again,” said Chatwell, Mizuho’s head of multi-asset strategy. “Over time, if the ETF inflows continue, this should allow the market to find balance.”