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.
Important Legal Information
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
Any companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance is not an indicator or a guarantee of future results.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton’s U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
This information is intended for US residents only.
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.
For more information on any of our funds, contact your financial advisor or download a free prospectus. Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money.
To comment or post your question on this subject, follow us on Twitter @LibertyShares and on LinkedIn.
To get insights from Franklin Templeton delivered to your inbox, subscribe to the Beyond Bulls & Bears blog.
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.