The average discount on fixed income ETFs, across the industry, has widened to levels not seen since the financial crisis1. While some may view this as an issue with fixed income ETFs, structurally this is what we’d 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 ETF’s NAV reflects an estimate of the value of an ETF's underlying portfolio. Typically, that NAV is likely to be fairly accurate. However, in a volatile market, like today’s, difficulties in pricing and trading fixed income securities will impact the estimate of the fair value of that basket of 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.
There are also structural factors that can lead to wider than normal premiums and discounts during periods of volatility. Fixed income NAV prices are typically struck as of 3 p.m. EST – and ETF trading that continues from 3 to 4 p.m. can lead to distorted premiums/discounts relative to those NAVs struck at 3 p.m. Importantly, we have recently seen plenty of market-moving news break well after 3 p.m. that has impacted the level of a fixed income ETFs discount, as the market is incorporating real-time news while the underlying market is closed. This is the ETF acting as price discovery tool.
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 ETF’s price may better reflect actionable prices to trade constituents.
Further, despite higher relative ETF trading volumes – fixed income ETFs traded a record $47 billion on February 28, only to break that record on March 9 with $53 billion, and have traded three times their normal daily volume from February 21 to March 17, 2020 compared to the same period in 2019,2 – we have not seen a large uptick in primary market activity. This could further indicate that underlying market liquidity is not being properly reflected by NAV pricing sources.
Focus on Execution Strategies
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).
Work with your respective execution desk or liquidity provider to source liquidity not displayed on screen.
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 with questions and for guidance.
1 Bloomberg Finance L.P. as of March 17, 2020 calculations by SPDR Americas Research 2 Bloomberg Finance, L.P., as of March 17, 2020
Net Asset Value (NAV) The value per share of a mutual fund or an exchange-traded fund (ETF) on a specific date or time.
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