Why stale prices in underlying bonds caused Fixed Income ETFs to trade at discounts

Dan Barnes Welcome to ETF TV – your insight into the ETF universe for issuers and investors. I’m Dan Barnes and with me is Deborah Fuhr, also of ETF TV. Today, we’ll be talking about the impact of recent events in the markets, market volatility and impacts on pricing. We’ve seen a number of mutual funds have to shutter as they try to assess their net asset value, because they weren’t able to get prices from dealers. And we’ve also seen some concerns in the exchange traded fund community about the capacity of firms to match the liquidity of the ETFs with the underlying instruments. Deborah, can I first ask you, what do you think have been the biggest impacts of recent volatility upon exchange traded funds?

Deborah Fuhr Well, maybe some other things I would point out is that ETFs have performed really well. If you’ve seen the volume being traded, they’ve been able to handle that large volume going both in and out, secondary trading, as well as we have seen significant redemptions without problems. Where we have seen issues that people have highlighted, is due to the fact that a lot of bond prices underlying ETFs are stale. So what ends up happening is it looks like the ETFs are trading at a discount, but the reality is that the authorized participants who have to go and trade the underlying bonds, have to figure out what is a fair price for those bonds. And to do that, you’ll find that they are discounting the price of the bonds relative to where it is in the NAV. And that’s why you see that many of the ETFs are trading at discount, but that really is a more accurate value of what the price of the bond is, than the stale NAV.

Dan Barnes One of the things that we seen Nordic bond funds have to do is actually shutter as they try to calculate the best asset value, either overnight or perhaps over the weekend by going out to banks, getting the prices of the bonds of their holdings and then coming back in order to support redemptions for their clients. Have you seen that for any exchange traded funds?

Deborah Fuhr No, but I think the discount that I’m talking about is a reflection of that, so people are basically going out and pricing the underlying bonds real time and then coming back, saying, ‘if you want me to trade and do a creation, this is going to be the price that we’re actually going to be trading at or this is the redemption price that we’re going to be redeeming at,’ so I think it’s happening much faster. And that’s one of the benefits of ETFs, is that you have these large firms who have access to prices, being able to go out and test the prices and reprice the actual value of the ETF, even though the NAV looks a bit stale.

Dan Barnes That’s really interesting because, of course, we’ve heard a lot of criticism of ETFs, particularly bond ETFs, talking about volatile markets and suggesting that actually they would underperform or create problems. But actually, for most investors, the biggest problem when you’re trying to get out of a fund is that you can’t in a volatile market. So actually seeing a discounts on an ETF rather than shuttering a mutual fund fx, would seem to be a lesser of two evils.

Deborah Fuhr Exactly. I think that’s one of the benefits that people found for ETFs vs mutual funds, is mutual funds tend to gate and say your stuck until we allow you to get out, whereas ETFs have so many different brokers who are looking to support them, that they’re able to come up with pricing and allow you to get out. So there’s always a price to get out. It’s whether you’re happy to take that price.

Dan Barnes One of the other things we’ve seen recently is index providers actually delaying, postponing the rebalancing the indexes they provide, the indicies they provide. Fx on Thursday on the 26th of March, we saw the data indices decided to postpone the rebalancing of their indices for a month. So anything happening in March is not going to directly affect indicies until 30th of April when they do that rebalancing. That’s an interesting step. What does that mean for investors?

Deborah Fuhr Well, I think it just means for investors that even the index providers are uncertain how all of this volatility over the long run is going to impact the composition of the underlying indices. We saw this also happen with S&P deciding earlier in the month that they weren’t going to rebalance the S&P 500 and the Dow Jones Industrial Average, which should have happened on March 20th, due to the 10% move that had happened earlier in the month. So I think what you’re finding is they’re afraid that the volatility might artificially create differences in the index composition, that doesn’t reflect the longer term, stable way that markets normally perform. And so I think that’s what they’re trying to avoid right now.

Dan Barnes Is this sort of cheating to avoid the actual situation of a market, knowing that it’s an unusual one?

Deborah Fuhr I’m not sure I would call it cheating. I mean, clearly, if you look at index providers, other ones decided to carry on with their index rebalances or at least say that’s what they’re going to do. So I think it’ll be interesting to watch because I don’t think anyone knows how long this is going to go on for. Right? So I think the news of COVID-19 is moving the market almost daily in the way it’s being dealt with. So I’m sure we’re going to continue to see volatility and that may impact other index providers going forward. But I think right now they’re saying they’re going to maintain their normal rebalance schedule.

Dan Barnes Deborah, thank you. That’s fantastic.

Deborah Fuhr Thank you.

Published on April 1, 2020