Bond ETFs Survived Their First Big Crisis
Claire Ballentine | Bloomberg | May 14th, 2020
Sam Huszczo had long been a skeptic. Exchange-traded funds, already wildly popular among equity investors, were emerging as a cheaper, easier way to build a fixed-income portfolio than investing in a mutual fund. But after a decade-long bull market, no one could be sure how the new products would perform in a downturn. Would they exacerbate turmoil in their underlying markets?
Finally, near the end of 2018, the founder of SGH Wealth Management in Southfield, Mich., decided to give them a try, investing about 27% of the firm’s assets in the funds. Throughout 2019, things seemed to be working well, Huszczo says. Then the coronavirus became a global pandemic, plunging stock and bond markets into a downturn.
Huszczo, like so many other money managers who overcame trepidations and piled into the new market, could only watch as the record volatility that plagued U.S. bond markets in March led to share prices of bond ETFs trading at deep discounts to the value of their underlying assets. On March 23 the Federal Reserve said it would buy corporate debt and eligible ETFs and then expanded the program weeks later to high-yielding securities to keep credit flowing.
“Everything was in a free fall until the Fed stepped in,” says Huszczo, who turns 39 in July. “No one likes to see their bond portfolio go down like that.”
By early May, with that big assist from the U.S. central bank, the consensus was that fixed-income ETFs had—for the most part—passed their first big test. But it was a roller-coaster ride along the way.
After years of sluggish growth, ETFs that track corporate or government debt last year took in more than $150 billion in the U.S., the most on record and just short of the sum attracted by equity ETFs. That’s boosted total assets to about $858 billion, or roughly 21% of U.S. ETF assets, data compiled by Bloomberg Intelligence show.
Critics and regulators have long voiced concerns that fixed-income ETFs, because they’re much more liquid than their underlying assets, would exacerbate price declines when investors scramble to redeem their holdings during periods of market stress. Mohamed El-Erian of Allianz SE and Scott Minerd at Guggenheim Partners are among veteran investors who have suggested ETFs could act as a destabilizing force in illiquid credit markets where they have an outsize trading share. (El-Erian is a Bloomberg Opinion contributor.)
When U.S. stocks fell more than 30% in March during the worst sell-off in history, bond ETFs showed signs of liquidity stress. Some of the hardest-hit were the Vanguard Total Bond Market ETF, or BND, and iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD.
In one notable example, on March 12, Vanguard’s BND was down 3.8% year-to-date, while its mutual fund counterpart—the Vanguard Total Bond Market Index Fund—was up 2.7%. The prices have since reunited, with both funds up about 3.7% so far this year as of May 11.
There’s debate within the industry over how to accurately value fixed-income ETFs and their holdings during such a period of stress: Is the true price the net asset value of the underlying securities or the cost at which you can execute trades?
Huszczo compares it to real estate websites that calculate “what our house is worth based off algorithms and comparables.” In reality, he says, “nobody believes that is the actual number. The actual number is just, ‘What is some other person willing to pay for this?’ ”
Opinions about the performance of debt ETFs come down to how investors understand the structure, explains Sue Thompson, who leads distribution of State Street Corp.’s SPDR ETFs in the Americas. “The dislocations happened first in the underlying market,” she says. “If there were not disruptions in the underlying markets, there would have been no disruptions in the ETFs, period,” she says.
Few market participants expect a slowdown in the momentum fixed-income ETFs have developed. The perks simply outweigh the dangers, they say.
For instance, ETFs allow asset managers faced with client redemptions that once would have forced them to sell their most liquid bonds to instead sell a slice of a group of bonds in the form of ETF shares. Their portfolio won’t look drastically different afterward. And ETFs, because they’re so liquid, can be used to park cash until it’s needed to purchase new bonds.
These funds can also make portfolio trading more efficient. When an asset manager wants to offload a bunch of bonds, intermediaries are willing to purchase them as a whole package because they can turn around and sell the inventory into ETFs. Last year, Wall Street’s bond desks executed at least $88 billion worth of such trades, according to an analysis by Morgan Stanley. That’s compared with virtually none two years ago.
“This may be—while a large blip on the radar—a blip on the radar,” Sullivan says. “I don’t think anyone is running for the hills from ETFs.”
Huszczo certainly isn’t. “We’re not going to rush to judgment over a couple of days. Investing for our purposes is long term,” he says. “ETFs did what we expected them to do.”