The liquidity crunch in Canadian Bond ETFs

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Critics sometimes say that ETFs propose only an illusion of liquidity, that in times of stress their prices will move far away from their underlying net asset value (NAV) and leave investors with significant losses.

In a 2019 study (Can ETFs contribute to systemic risk), the European Systemic Risk Board (ESRB), looking for potential detonators of systemic financial risk, wrote: “ETF prices can deviate significantly from those of the constituent securities, especially at high frequencies, for illiquid assets and during periods of financial stress. Such decoupling results from “authorized participants” not having the incentives and/or the capacity to realign ETF prices with those of the constituent securities in times of financial stress. In these situations, the order flow may have a strong adverse impact on ETF prices, which could lead investors to “lose faith” in the liquidity transformation provided by ETFs and engage in potentially destabilizing fire sales.”

Some of this reflects the present reality in the bond ETF market: price deviation of ETFs from constituent securities, incapacity of authorized participants to realign prices, fire sales.

By March 25, Canadian bond ETFs showed “significant discounts (to NAV)” across the board, says Daniel Straus, vice-president, ETFs & Financial Products Research, at National Bank of Canada Financial Markets. Discounts stood anywhere between 5% and 10%, while “some ETFs traded at eye-popping 15% to 16% discounts,” he adds.

Liquidity crunch
“On the corporate bond side, what we see presently are primarily sellers, not a lot of buyers, and people are not getting the liquidity that they normally would” says Steve Hawkins, CEO of Horizons ETFs.

The problem rests at the level of the secondary bond market. “What we see is a full liquidity crunch in the bond trading market place – and ETF prices are reflecting that,” Straus states. That problem plagues not only the higher risk corporate bonds, especially high-yield bonds, but even investment grade bonds. “The feedback we have received from the banks was that no one wanted to buy investment grade credit in Canada,” notes David Mann, head of Global ETF Capital Markets, at Franklin Templeton.”

Bond trading desks are frozen because traders “don’t know what corporations will look like at the end of the pandemic, explains Hawkins. Who will survive? Among those that have debt, some will probably have serious cash flow problems. Nobody wants to take the risks associated with that opacity right now.”

But...
What the ESRB study does not say is that, paradoxically, while there is a liquidity freeze among bond traders and “authorized participants”, there isn’t one in the bond ETF marketplace. “I disagree with the notion that ETFs provide an ‘illusion of liquidity’, says Hawkins, because there still is liquidity, even if it is at a discount and even if it is not an exact picture of where bonds are.”

As Morningstar’s director of global ETF research Ben Johnson explains, “bond ETFs trade while equity markets are open. Bonds trade when bond markets are open. The bond market closes an hour earlier than the stock market. Closing prices for bond ETFs are set an hour after the values for the bonds they hold are struck--the values baked into their end-of-day NAV. This mismatch explains a portion of the structural (that is, persistent and readily explainable) premiums and discounts we see among bond ETFs.”

In fact, ETFs are acting as a price discovery mechanism even for bond traders and authorized participants. The spread between the “theoretical” NAV and the “practical” market ETF price is bound to find a meeting ground between both values when markets stabilize. In the U.S., where discounts still ran as deep as in Canada at the beginning of the week of March 23, that meeting ground started to emerge at the end of that same week.

During that week, the Federal Reserve announced that it would start buying corporate bond ETF shares to bring liquidity to the market, and the U.S. government approved a $US 2.2 trillion stimulus package. Following that, discounts on bond ETF prices melted away in a matter of days and even ended the week trading at a premium. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which the Fed had been heavily purchasing, ended that week with a 3% premium.

In Canada, last Friday, at the same time that it was cutting its policy rate, the Bank of Canada announced that it would start purchasing commercial paper (corporate bonds) and government of Canada bonds.

This is not a call to start trading bond ETFs. In fact, as we explained earlier this week, retail investors should stick to their financial plans, and avoid trading ETFs, especially on impulse. A key signal supports this view: at the end of the week of March 23, the same day LQD and other bond ETFs were starting to sell at a premium, the S&P/TSX was tumbling again by 5% and shares globally had fallen by 3-4%. The Globe and Mail saw in all this “a sign investors were focusing once more on the spread of the virus despite hopes of further stimulus to combat its economic impact.”