COVID-19 anxiety and a potential oil price war have contributed to increased volatility in global markets. Fixed income markets have not been immune, for example the 10-Year Australian government bond yield has seen an increase in its intraday volatility. On 13 March 2020, the 10-Year Australian government bond yield reached a high of 1.08% and a low of 0.78%, meaning that the yield moved within an intraday range of 0.30%.1 As the chart below displays, prior to the COVID-19 crisis, the intraday range was on average 0.04% and between 0.01% and 0.07%.2
As the intraday volatility of the 10-Year Australian government bond yield increases, the impact on the actual bond prices is compounded by their duration. As a result of the increased intraday volatility, institutions making markets on fixed income ETFs had to widen their bid offer spreads in order to hedge this additional risk. On 13 March 2020, the average bid ask spreads of Australian fixed income ETFs on the Australian Securities Exchange (ASX) was more than 1.30%.1 As shown in the chart below, prior to the COVID-19 crisis, the average bid ask spreads were on average at 0.13%.2
The recent turmoil in the bond market has also led to the average price premium/discount vs NAV of Australian fixed income ETFs to drop to an unprecedented level across the Australian industry. On 13 March 2020, Australian fixed income ETFs closed at average discount of 2.2% vs their NAV.1
While some may view this as an issue with fixed income ETFs, structurally this is what we would expect because investors are using ETFs as price discovery tools. The discount simply reflects the fair market price between willing buyers and sellers based on their assessment of the valuation of the underlying bonds – some of which may not have traded recently.
NAV Pricing Can Be Stale in a Volatile Market
At its most basic level, an ETFs NAV reflects an estimate of the value of an ETFs underlying portfolio. Typically, that NAV is likely to be fairly accurate. However, in a volatile market, difficulties in pricing and trading fixed income securities will impact the estimate of the fair value of that basket of bonds.
There are structural factors that can lead to wider than normal premiums and discounts during periods of volatility. Companies usually issue a number of bonds with different characteristics such as maturities, sizes and coupons. These bonds will have different liquidity profiles and a more limited liquidity due to the fragmentation of trading across all these bonds. On-the-run bonds usually have a higher liquidity than off-the-run bonds. The price of more illiquid bonds may need to be estimated from the price of more liquid bonds.
When underlying fixed income market liquidity becomes constrained, pricing becomes increasingly opaque. And individual bond pricing can lag real-time market sentiment as well as realistic pricing levels. Real-time sentiment, however, will show up in fixed income ETF market prices on where the market deems that basket of bonds should trade, based on prevailing macro information and the assessment of risk.
ETFs Remain at Least as Liquid as their Underlying Constituents
The other structural aspect is that the large discounts in fixed income ETFs are likely reflecting market participants’ inability to trade underlying bonds at levels reflected in (potentially stale) NAV valuations. Therefore, as stated above, the ETFs price may better reflect actionable prices to trade constituents.
How to Navigate Volatile Markets? Reach out to the Capital Markets Team
With fast-moving markets and uncertainty related to underlying pricing, ETF execution strategies become more important. We continue to advise that investors trading any ETF should:
Use limit orders, not market orders.
Avoid the market open (first 30 minutes of trading).
Avoid the market close (up to last hour of trading).
As we’ve seen in other periods of stress, ETF volumes have spiked as investors have gravitated to the transparency of exchange trading to make real-time asset allocation decisions and source liquidity at a time when they demand it most. And we encourage investors to contact us or your investment professional with questions and for guidance.
1Bloomberg Finance, L.P., as of 13 March 2020. 2Bloomberg Finance, L.P., figures based on the period 2 January 2020 to 28 February 2020.
Glossary / Definitions
On-the-run bonds are those which are currently being issued by the government.
Off-the-run bonds are those where there is no active issuance being undertaken.
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