Since the beginning of the market sell-off in May and June, a number of clients have asked about fixed income exchange-traded fund (ETF) liquidity.
Our analysis of 2Q2013 prices for shares of the largest fixed income shows that ETF prices were more volatile than those of their respective indices, and, in many cases, far more volatile. Excess volatility ranged from just 10% to more than 150%, and appears to be a function of both the breadth of the underlying index and the liquidity, or lack thereof, of the underlying securities. The lack of bond market liquidity even forced a small number of firms to suspend cash redemptions at times during the recent sell off.
Liquidity also impacted the prices of ETFs during the sell-off, with discounts reaching almost 4% for some municipal bond ETFs. Many market participants argue that, because ETFs offer intra-day liquidity, their prices are ‘early indicators’ that are actually more reflective of the actual market value than the mark of the underlying bonds. In many cases that may be true, as market values in the over-the-counter markets can reflect not just stale prices, but prices extrapolated from similar, but not the same, securities. Small comfort, however, for impacted investors. Essentially, fixed income ETFs are intra-day liquidity vehicles on top of markets that do not offer intra-day liquidity. For investors that may mean that you’re paying a premium to the NAV on the way in and receiving a discount to the NAV on the way out.
Passive, index-based funds are forced sellers of bonds that are in the index, in numbers proportionate to that security’s weight in the index. Contrarily, the managers of actively managed portfolios have discretion as to which securities to sell and which to retain. During periods of stress, bonds that are in the index may be under greater selling pressure than those that are not. In our experience, price declines were far more severe for bonds in the index than for bonds that are not.
Index-based funds may also be giving investors a greater exposure to individual credits than is desirable, as fixed income indices often reward ‘bad behavior’ (the more an issuer borrows, the larger their weight in the index). Consider the Barclays U.S. Aggregate Index, 36.5% of which was US Treasurys at the end of June, up from 25.2% at the end of 2005. Arguably, given the US Federal Reserve’s recent bond buying programs, US Treasurys are the most overpriced securities in the bond market, yet investment in the index results in a significant allocation to this sector.
Fixed income ETFs have become popular as investors look for low cost ways to gain exposure to segments of the capital market, but the experience of May and June highlights that intra-day liquidity comes with increased price volatility, and that volatility increases as the liquidity of the underlying securities decreases. Fixed income ETFs may be an easier and faster way to trade the bond market than using individual bonds. But at what cost? Mutual funds also offer an easy way to access the markets. Granted, they don’t offer intra-day liquidity, but they may provide more price stability. And active management can help avoid some of the risks of forced selling. That doesn’t mean that fixed income ETFs don’t have a role, but that investors need to be aware of just what an ETF does, and what it doesn’t.