In my last blog post, I discussed the Federal Reserve’s (Fed’s) Secondary Market Corporate Credit Facility, which included ETFs that provide exposure to investment-grade corporate bonds. More than a week later, the million-dollar question of “which ETFs?” remains unanswered.
The Fed’s announcement that it was going to buy ETFs is certainly a topic of interest within the ETF industry, as judged by the higher-than-normal amount of questions and comments I received. Interestingly, many of the comments were less about which ETFs and more focused on when the Fed would act.
As I went through the “when” scenarios, let’s imagine the two extreme scenarios of when the Fed would buy ETFs. As a reminder, we estimate around $140 billion of assets under management (AUM) across 60 funds that meet the Fed’s eligibility criteria.
Extreme option 1: There is a massive amount of simultaneous selling pressure ($28 billion) across ALL eligible ETFs. The Fed acts in reaction to this selling pressure by buying ETFs.
Extreme option 2: There is zero selling pressure in the market, and the Fed decides to buy $28 billion of ETFs.
Admittedly, my last post was written in the mindset that the Fed’s program would be proactive in its approach (closer to option 2). I would argue that the market thought so as well—the week of the announcement saw the top five ETFs that provide exposure to investment-grade bonds bring in around $6 billion in assets.
Furthermore, those funds had an average premium to net asset value (NAV)1 of almost 1.5% on the back of almost $40 billion of notional volume. Those actions reflect a market that expects a big buyer to enter sometime soon. We will have more on this in our next post.
For this discussion, even though I think it is very unlikely, I went through the thought exercise of how this program would work if the Fed elects to buy these fixed income ETFs reactively to extreme selling pressure.
- First, the realistic universe of ETFs to be purchased would be limited to the largest investment-grade ETFs as was initially speculated, since they would have the highest number of possible sellers.
- The Fed (via BlackRock) would essentially be acting as a real-time ETF market maker, determining the “fair value” of those ETFs.
- Once the ETFs start trading “cheaply” to their fair value, the Fed (BlackRock) could then either a) buy the ETF shares on exchange or b) allow the ETF liquidity providers to buy the ETFs, wait for them to submit redemption orders with the fund to receive the underlying bonds in return, and then buy those underlying bonds from those ETF liquidity providers.
For now, let’s put to the side the anti-competitiveness of only using large funds and the many challenges for the Fed (BlackRock) to serve as a real-time ETF market maker (nimbleness, technology, conflicts of interest, etc.) Those alone make a quick reactive purchase seem unlikely.
But playing out our thought exercise, let’s assume we get past those first two hurdles. We now have the two options of how the Fed would use extreme selling pressure of an ETF as the driver of supporting the investment-grade bond market.
First, buying ETFs on exchange means there would be no buying of the underlying bonds. This is what I discussed previously, but in summary, the Fed (BlackRock) is just as likely to be buying from professional high-frequency trading firms who trade those funds like single stocks as they would from actual retail sellers. That cannot be the goal here, in my view.
The second option described above is essentially the Fed buying underlying bonds. If that is the case, it should either leave the ETF out of the equation altogether, or use ETFs that will ensure purchasing of the underlying bonds, as I discussed in my last post.
So “reactive” buying seems very unlikely. And given the trading and flows we saw post-announcement, the need for proactive buying of ETFs by the Fed is probably not needed right now either. Put another way, if the threat of buying does the job, then the answer to “when” might be never. I will discuss the implications of that in my next post.
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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.