Some are blaming ETFs for increasing volatility in the markets, writes Gary McFarlane.
In a sign of the extreme pressures building up inside the financial system, the Vanguard Total Bond Market Index Fund ETF (BND) has moved to an unprecedented discount to its net asset value.
On 12 March, BND traded at a discount of 6.2%. This is unusual because exchange traded funds (ETFs) are replicating an underlying asset or market and therefore their prices will typically be closely aligned to their net asset value. Vanguard’s BND fund at its height held assets under management of $55 billion.
The difficulties are by no means confined to Vanguard bonds funds. Analysis by Reuters found European government bond ETFs were seeing large spreads opening up between their price and net asset value, with discounts of anywhere between 2% and 11%. Affected funds include the iShares Core European Government Bond ETF and the BNP Paribas Euro Aggregate Treasury Bond ETF.
Research and data analytics firm EPFR Global reported that across both ETFs and open-ended funds, outflows reached $109 billion by Wednesday this week. Data provider Lipper reckons $55.9 billion has been redeemed from bond funds alone. The beneficiaries are money market funds, which are viewed by investors as near-cash equivalents; inflows topped $148 billion by Wednesday.
Adrian Lowcock, head of personal investing at investment platform Willis Owen, told Money Observer that there has long been concern about the bond markets. He says we are now seeing what happens “when everyone wants liquidity and to get their money out”.
“Bond traders are finding they can’t find buyers and some of that is because of the policies implemented to get out of the 2008 crisis, which reduced the role of banks as market makers.
“One of the cures of the financial crisis was for banks to effectively reduce their balance sheets and secondly not hold stock on their books anymore, which makes trying to buy and trade bonds a harder because you don’t have the middleman.
“Before, a trader could perhaps go to just one bank but now they are having to make a lot more phone calls to perhaps half a dozen banks to try and find stock,” Lowcock explains.
Regarding ETFs, Lowcock points out that they are a quick way to gain exposure to an asset “but they are also a quick way to remove exposure from an investment”.
Some are blaming ETFs for increasing volatility in the markets. Lowcock agrees: “ETFs will have contributed to the illiquidity in markets. Liquidity works both ways, although compared to the property sectors you might say that’s not necessarily a bad thing, but yes, ETFs contribute to increased volatility.”
The strong US dollar and access to debt is an issue bearing down on emerging market sovereign debt but Lowcock says it is important to differentiate between the various countries in terms of quality. Although there are risks in those regions, he warns that the concern, looking into the future, should perhaps be focused elsewhere.
He adds: “There’s a multi-decade issue when we come out of this. The view that it is the emerging markets are heavily indebted and really bad is going to shift to the UK, the US and the eurozone. They are already so highly indebted and yet they are having to rise enormous amounts of money. If you don’t get your house in order in time, then the next crisis is going to be in the governments”
As investors rush for the exit they have been liquidating assets – even traditional safe havens such as government bonds and gold – in order to raise cash.
Corporations are also part of the dash for cash, as they hoard in order to build up reserves to weather the collapse in demand that is taking hold.
As a result, the US dollar has been strengthening against all currencies despite the US Federal Reserves cutting the Fund Rate to the 0-0.25% range, which in normal times would weaken the currency. This is further adding to volatility and illiquidity issues in the bond markets.
Wild gyrations in the normally relatively tranquil credit markets has been the order of the day, with yields rising as investors sell.
In the past couple of days that trend has started to reverse as the restarting of quantitative easing programmes sees central banks buy up corporate and government bonds. Bond prices fall when yields rise and vice versa.
In the past two weeks the closely watched US 10-year Treasury bond has traded between as low as 0.569% to 1.056% currently.
Lowcock says some of the unprecedented liquidity and price discovery breakdowns in US government bond market may be related to timing: “There was a liquidity issue in US Treasuries a few days ago as well which is pretty much unheard of. Also, there’s an issue [with funds] of timing for the pricing of the index versus the underlying investment. So, a fund might be priced at 12 noon but the benchmark not until 5pm, so some of that might have contributed [to the problems] with ETFs.”
There are fears that many of the larger bond funds may hold some problematic high-yield corporate bonds, that are currently among the most difficult to price.
The Vanguard bond fund’s holdings to 31 December 2019 were 43% in government bonds, 24% asset and mortgaged backed securities and 16% in industrials, according to FE Analytics.
The flagship Vanguard fixed income product normally trades at a small premium, averaging 0.17% since its launch.
BND has moved from a year-to-date total return high of 5.73% to -0.29% on 18 March.
Despite the unusual price movements, a Vanguard spokesperson said: “Market prices for ETFs can move more rapidly than the net asset value. That is part of the price discovery process.”
Lowcock says investors need to focus on quality in both the bond market and equities.
He sees the most immediate trouble in the bonds of companies in the US shale gas sector, among cruise firms and airlines.
“The high-yield sector is basically where the zombie companies are. Those that were allowed to continue to exist post the financial crisis. They were given a lifeline for 10 years.
“If you are investing in bonds, quality is the place to invest – good companies with a good financial record.”
The problems with bond ETFs, which now account for a sixth of the entire $6.4 trillion ETF market, has raised doubts about the continued growth of the exchange traded funds. Lowcock thinks the jury is still out on that and we need to get past this crisis first to get better visibility.
“What is clearly coming out from fund managers, though, is that what will matter going forward, and what will matter through this crisis, is the quality element.
“If you’ve got a strong balance sheet as a company and you’ve got cash in the bank and continue to function for six months, even if you’ve got no customers, then you will able to come out the other side. If you don’t [have the cash] then the writing is on the wall at the moment. That sort of implies that active funds should do better than passives,” Lowcock concludes.