Possible Bond ETF Problems by David Merkel, CFA of The Aleph Blog
There have been a few parties worrying about crises stemming from ETFs, because they make it too easy for people to sell a lot of assets in a crisis.
I think that fear is overblown, but I don’t think it is non-existent, and I would like to use a bond ETF as an example of what could be possible.
Most bonds don’t trade every day. Only the most liquid bond issues trade every day, and they form the backbone for pricing the bonds that don’t trade.
But how do you price a bond when it doesn’t trade? It’s complicated, but let me try to explain…
When a less liquid bond actually has a trade, the bond pricing services take note of it. They calculate the yield spread of the less liquid bond versus similar bonds (similar in industry, rating, maturity, currency, domicile, other features) that are liquid, and compare it to:
- where that yield spread was in the past
- where the yield spread is relative to other similar less liquid bonds that have recently traded
- where models might imply the yield spread should be, given other securities related to it (stock, preferred stock, junior debt, other bonds in the same securitization, etc.)
- where investment banks that make a market in the bonds are indicating they would buy or sell.
Now consider that the bond pricing services are doing this for all the bonds they cover every day, and in real time when the NAVs are made available for ETFs. The bond pricing services attempt to create a set of prices for all securities that they cover that is consistent with the market activity in aggregate, adjusting at a reasonable speed to changing market conditions. It’s complex, but it allows investors to have a reasonable estimate of the value of their bonds.
(Note: the same thing is done with illiquid stocks as a result of the late trading scandal in mutual funds back in the early 2000s for setting the NAV of mutual funds — less liquid stocks have the same problem in a lesser way than bonds.)
The technical name for this is matrix pricing, which is a bit of a misnomer — multifactor pricing would have been a better name. It works pretty well, but it’s not perfect by any means — as an example, you can’t take the calculated price and trade at that level — it is only indicative of where an uncoerced buyer and seller might trade on a normal day. It may be a useful guide, though your broker making a market may disagree, which is part of the art of understanding value in the bond markets.
The Possible Problem
Now imagine an ETF with a relatively large amount of less liquid bonds in it, and a market environment where yield spreads are relatively tight, as it is now. In such an environment, even the less liquid bonds may have their yield spreads relatively tight versus their more liquid cousins. Now imagine that a relatively violent selloff starts in the bond market over credit issues.
If you were a bond manager at such a time, surprised at the move, but thought it would go further, and you wanted to lighten up on some of your positions, would you try to sell your liquid or less liquid bonds first? Most of the time, you would sell the liquid ones, because it is relatively easy to get the trades done. If the selloff is bad enough, it will be impossible to sell the less liquid bonds — practically, that market shuts down for a time.
But if there are very few trades of the less liquid bonds, what does the pricing service do? Initially, it might rely on the old spread relationships, leaving the less liquid bonds with higher prices than they should have. But with enough time, a few trades will transpire, and then the multifactor models will catch up “all at once” with where the pricing should have been.
For a time, the NAVs would be high relative to where the bonds actually should trade. The unit creation/liquidiation process might not catch up with it, because the less liquid bonds are difficult to source, and there is often a cash payment in lieu of the less liquid bonds. That cash payment figure could be too high in my scenario, leading to a rush to liquidate by clever investors sensing an arbitrage opportunity.
Now, would this be a catastrophe for the markets as a whole? I don’t think so, but some investors could find the NAVs of their bond ETFs move harder than they would expect in a bear market. That might cause some to sell more aggressively, but remember, for every seller, there is a buyer. Someone outside the ETF processes with a strong balance sheet will be willing to buy when the price is right, because they typically aren’t forced sellers, even in a crisis.
If you own bond ETFs, know what you own, and how much of the portfolio is less liquid. Have a passing familiarity with how the NAV is calculated, and how units get created and liquidated. Try to have a sense as to how “jumpy” investors are in the asset sub-class you are investing in, to know whether your fellow investors are likely to chase market momentum. They may cause prices of the ETFs to vary considerably versus NAVs if a large number of them take the same action at the same time.
Know yourself and your limits, and be willing to hold or add when others are panicking, and hold or sell when others are too optimistic. If you can’t do that, maybe hand it over to a financial advisor who stays calm when markets are not calm.
Till next time…