Yes, Bond ETFs Can Go Haywire. But That’s a Good Thing, Says BIS

(Bloomberg) -- Critics of the passive-investing boom in bonds warn about the risks stemming from the mismatch between highly tradable ETFs and the illiquid securities they hold.

Turns out this very discrepancy might help stabilize the market, according to the Bank of International Settlements.

The latest quarterly report from the Basel-based central bank for central banks explores the mechanism that regulates the price differences between fixed income exchange-traded funds and the bonds they own.

The surprising conclusion: Yes, the two values can be wildly different, but that disconnect is a key shock absorber for the market.

When money flows into an ETF, a market maker known as an authorized participant (AP) buys more of the assets the fund holds and swaps them with the issuer for new shares. When cash flows out, that happens in reverse.

The BIS found that the bucket of securities exchanged for shares in a typical aggregate bond fund matches just 3% of the ETF's holdings. That basket can change dramatically from day to day, and even differ from AP to AP. It's this very elasticity that gives bond funds their resilience.

“The flexibility inherent in baskets' composition may allow ETFs to withstand episodes of market stress,” the BIS's Karamfil Todorov wrote. “In the face of panic selling (runs), which generates redemption pressure, ETF sponsors could tilt redemption baskets towards riskier or less liquid securities. This would decrease prices of ETF shares since shares are exchanged for a lower-quality subset of ETF holdings.”

Meanwhile, investors who don't bail out benefit from the average quality of bonds in the ETF improving, the economist wrote.

Put another way: the issuer can make it less appealing for the AP to redeem shares, making exits from the fund less likely -- and limiting contagion in the broader market in the process.

The cost of this flexibility is the premiums and discounts that can afflict some bond ETFs. APs may be more reluctant to transact with the fund because of uncertainty over what securities it will accept or spit back out, and that weakens the arbitrage mechanism, the paper said.

Indeed, premiums and discounts in fixed-income ETFs can be much wider than for their equity counterparts.

During last March's turmoil, scores of fixed-income ETFs traded at discounts of 5% or more to their net asset value, while a handful traded at a discount of 10% or more. Those disparities only corrected themselves when the Federal Reserve stepped in to support the credit market.

But ultimately, the study suggests that bond ETFs' willingness to accept and redeem baskets of securities bearing little similarity to their holdings prevented far greater turmoil in the wider market.

In the past, some market participants have raised concerns that this could store up trouble for ETFs. The suggestion is that in order to maintain orderly trading, the funds might give away their most liquid securities, leaving them with a portfolio of riskier and less-liquid assets.

That would risk the fate of the fund, so seems unlikely. But there remain dangers to deploying the shock-absorbing mechanism observed by the BIS.

If the fund only offers poor securities in the redemption process and APs stop working, prices will disconnect further than they would have done. That could turn off investors.

“Such a strategy can backfire in the long run,” Todorov acknowledged in the report. “If investors perceive an ETF as redeeming only low-quality bonds in stress times, they may withdraw from the ETF altogether.”

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