Beyond Bulls & Bears


The Road to Premiums is Paved with Good Intentions: Perspective on the Fed and ETFs

The US Federal Reserve recently announced a number of measures to support the economy and markets amid the coronavirus crisis. One involves the purchase of fixed income exchange-traded funds (ETFs). David Mann, Head of Capital Markets, Global ETFs, shares his thoughts on the subject, and what he thinks is the best way to support the corporate bond market through these purchases.

In my last post, I noted that the Federal Reserve (Fed) might start buying some corporate bond ETFs  as part of its Secondary Market Corporate Credit Facility (“Facility”).

To summarize the key ETF references in the release notice:

  • Eligible ETFs. Any US-listed ETF whose main objective is to provide exposure to the US investment-grade corporate bond market.
  • ETF Limits: The Facility will not purchase more than 20% of the fund’s assets as of March 22, 2020.
  • ETF Pricing: The Facility will avoid purchasing shares of eligible ETFs at premiums to net asset value (NAV).1

The Million-Dollar Question: Which ETFs Are They Going to Buy? 

Let’s start with eligibility. As of March 22, we estimate there are around 60 ETFs focused solely on US investment-grade corporate bonds, with combined assets under management (AUM) of approximately $140 billion. These funds range from the very big ($30 billion+) to the very small ($3 million) and include both active and passive strategies.

Now, if by the time you read this it is announced that the plan is simply to buy 20% of all of those funds, thus leading to a nice ETF investment of $28 billion across the board, feel free to click that “X” in the upper right corner of your browser right now.

Assuming that is not the case, then some decisions need to be made on which ETFs should be included in the Facility. The early speculation is that the investments would only go into the largest investment-grade bond ETFs.

I think that would be a huge mistake, and completely counter-productive to the spirit of the Facility.

The purpose of the Fed’s Facility is to support the corporate debt market by purchasing corporate bonds and/or corporate bond portfolios via ETFs. Purchasing only the largest ETFs with the highest average daily volume will not achieve this goal. One of the most frequently touted soundbites from the ETF community (especially the community that has high volume funds) regarding fixed income ETFs is some version of: “the fixed income ETF serves as a price discovery vehicle, allowing buyers to transact with sellers on exchange without having to impact the underlying bond market.”

Heck, I even said something very similar in my last post.

The ETFs with the most volume tout those high numbers as a liquidity benefit, specifically focusing on how little they impact the underlying market. That is the opposite of what is needed here! We want that ETF volume to impact the underlying bond market!

A very crude metric to measure the impact an ETF has on the underlying bond market is looking at the ratio of exchange volume to create/redeem volume. A ratio of 1:1 would mean every dollar traded on exchange is flowing into the underlying bond market. A ratio of 4:1 would indicate only $0.25 of every dollar traded on exchange leads to the buying or selling of bonds.

To give a sense of that ratio for the top five largest ETFs, they have a weighted average ratio of 5:1. Only $0.20 of every dollar of exchange volume in those funds results in trades in the underlying investment-grade corporate bonds market.

The Facility should want low ratios as those ETF trades would lead to actual buying of the underlying bonds. Our recommendation would be to focus on low-ratio ETFs (for example, under 3:1 over the past 12 months) as we want that primary market activity.  Purchasing high-ratio ETFs may not even lead to any buying of the underlying bonds, depending on what is happening in the market that day.

The 3:1 universe has a combined AUM of around $40 billion, which would lead to an $8 billion ETF investment that should flow directly to the underlying bond market. Mission accomplished!

If for some reason the intent was to buy ~$28 billion of investment-grade ETFs, then the Fed could simply raise its ownership percentage to make the math work.

One final benefit? Investing across a wide range of ETF issuers is consistent with some of the SEC concerns from last year on anti-competitiveness within the ETF industry. Our subset of fixed income ETFs includes funds from both large and small issuers.

In my view, only picking the largest investment-grade corporate ETFs would not only be anti-competitive, but would also be completely against the intent of the Facility.

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What Are the Risks?

All investments involve risks, including possible loss of principal. Generally, those offering potential for higher returns are accompanied by a higher degree of risk.  Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

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1. Net Asset Value (NAV) represents an ETF’s per-share-value. The NAV per share is determined by dividing the total NAV of a fund by the number of shares outstanding.

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