You don’t need to be an expert in financial market structure, nor in fixed-income investing, to understand that an “illiquidity doom loop” is a very bad thing.
This phrase made its first appearance in a Bloomberg News article on Friday, March 20, when Mizuho International Plc’s Peter Chatwell raised the alarm about certain exchange-traded funds tracking the bond markets. By that point, I and others had flagged some of the most extreme cases of ETF share prices deviating from their net asset values. Chatwell’s concern was that with widespread fear gripping the financial world, investors rushing to redeem ETFs would cause forced sales of the underlying bonds at sharply lower prices, which would cause the ETFs to tumble further, which would hasten an exodus from the funds. And on and on it would go, until some ETFs imploded.
This was hardly hyperbole. In the week ended March 18, investors pulled $35.6 billion from U.S. investment-grade funds, an unprecedented sum that vastly exceeded the previous record of $7.27 billion, set just a week earlier. They also pulled $12.2 billion from muni mutual funds, almost three times the previous record of $4.5 billion, along with $2.91 billion from high-yield funds and $3.45 billion from those tracking leveraged loans. I warned that bond markets were quickly veering into a vicious cycle, similar to the doom loop that Chatwell envisioned around the same time.
That worst-case scenario didn’t happen, of course. That’s largely because after the weekend, and before U.S. markets opened again for trading on March 23, the Federal Reserve unleashed what it called “extensive new measures to support the economy.” Chief among them: The Secondary Market Corporate Credit Facility, which would buy not just corporate bonds but also “U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.” That, combined with Minneapolis Fed President Neel Kashkari’s vow that there’s “an infinite amount of cash” at the central bank, helped propel U.S. equities and other risky assets from their lows. Investors haven’t looked back and have pushed markets back into record territory.
But history ought to remember just how close the fixed-income ETF industry came to a reckoning. Just hours before the Fed announced its new facilities, I published a column titled “Bond ETFs Will Never Be the Same After Coronavirus.” It followed the saga of a BlackRock Inc. ETF (ticker: NEAR) that invests in high-quality short-term bonds, which plunged by the most on record based on rumors the world’s largest money manager was restricting cash redemptions. In theory, that shouldn’t happen, ever. Again, without knowing the Fed would intervene just hours later, I came to this conclusion:
While it’s possible that NEAR and the other ETFs will recover soon from their violent drops and company missteps, this feels like a moment of truth for the fixed-income ETF industry. If investors are simply turning to them for instant price discovery and liquidity, then the funds have certainly held up their end of the bargain. If, however, institutions expected the ETFs to minimize tracking error to a benchmark index, they’ve been let down amid this market turmoil. Heading into Friday, roughly 70 fixed-income ETFs were trading with at least a 5% discount to their net asset value, and 16 traded at a discount of 10% or greater.
“This is the problem with ETFs: You are basically offering a vehicle that gives the end-investor minute by minute liquidity, but the underlying assets can’t be sold in that period of time,” Nick Maroutsos, head of global bonds at Janus Henderson Investors, told me recently in an interview. “That mismatch created an issue, and I think market makers certainly got spooked.”
The fear of a liquidity mismatch in fixed-income ETFs has been around practically as long as the funds themselves. And yet, time and again, they’ve seemingly held up during periods of market stress and proved the skeptics wrong. Indeed, in October 2018, as the high-yield debt market cracked, trading volume surged in the largest junk-bond ETF (ticker: HYG). It was hard not to conclude at the time that ETFs helped two-way flow and price discovery more than they hurt it.
March 2020 was a different beast entirely. In the U.S., some states and cities went on lockdown. In Europe, entire countries were effectively closed. The Fed had just slashed interest rates to near-zero, a move that indicated policy makers expected the worst, and yet it still wasn’t clear what the global economy would look like in six weeks, let alone six months. Every financial asset was on sale; cash was king.
“It was certainly a scary time for us because we were looking at our portfolio and going, ‘Hold on a second — we did everything correct leading up to the Covid crisis,’” Maroutsos said of his ETF (ticker: VNLA). “We increased cash 30%. We increased the quality of the book. And our ETF was marked down. And we’re looking around at each other thinking ‘what’s going on?’ These are high-quality assets that we can certainly get out of if we needed to. But it was the market makers across the board who were just repricing all of these assets and they just wanted to protect themselves — which I get.”
Many of the largest market makers, of course, are primary dealers, the preferred trading counterparties of the New York Fed as it conducts monetary policy. And primary dealers are required to provide data to the New York Fed on their market activity. It doesn’t take much to connect the dots and conclude that the Fed saw Wall Street’s struggle to properly price credit market risk and sprung into action. On March 20, the average high-yield bond spread was more than 1,000 basis points above Treasuries, three times what it was heading into the year.
“For sure, bond ETFs provided some liquidity to the markets, but not enough,” said Bob Michele, global head of fixed income at J.P. Morgan Asset Management. “When you look at some of the discounts to NAV that appeared, you have to step back and say there’s some liquidity, but when the price is too great, it’s no longer a properly functioning market — then you need an official agency to step in and help out.”
Others aren’t so sure bond ETFs should get a bad reputation from their performance during the Covid-19 crisis. They “came through with flying colors,” said John Hollyer, head of fixed income at Vanguard Group Inc. “I have a much more glass-half-full view of bond ETFs.”
For Hollyer, the bond ETFs with huge discounts to their NAV were in more niche parts of the fixed-income market rather than broadly diversified funds. The Vanguard Total Bond Market ETF (ticker: BND), for instance, had a discount of about 6% on March 12, which corrected to 1.7% the next day. While it was obviously the largest rift in its history, “the discounts were moderate and they were in line with what the transactions costs in the market were at the time,” he said.
Hollyer called fixed-income ETFs “much more transformational to bond market structure than equity ETFs ever were.” I agree. The rise of portfolio trading, for instance, in which Wall Street dealers either “create” ETF shares by supplying a basket of bonds or “redeem” shares by taking out the underlying securities, makes life significantly easier for managers of large bond funds. Vanguard, for its part, does these basket trades in both its index funds and actively managed funds, which helps keep its fees low.
Yet for all their benefits, it’s fair to wonder what might have happened if the Fed didn’t step in when it did. Especially given that a provision in the $900 billion U.S. relief plan prohibits the central bank from restarting many of the new programs it rolled out last year, including its credit-market facilities, without congressional approval.
Would there have been an “illiquidity doom loop” that took down some ETFs? Would mutual funds have hemorrhaged even more cash as investors grew anxious about widespread defaults? How many more companies would have gone bankrupt without primary debt markets opening back up quickly and providing emergency financing?
We’ll never know. But one thing’s for sure: The magnitude of March’s market meltdown tested fixed-income ETFs like never before. In many ways, judging whether they passed or failed depends on if you believe they should have to prove their mettle on their own during a crisis, or if a Fed backstop is just a feature of the modern financial markets.
Either way, bond ETFs survived — but only barely.
“At the end of the day, would I say ETFs were a failure or a success? I think without the Fed backing, there could have been some real problems, not only in ETFs but in mutual funds,” Maroutsos said. “But the Fed saved the day; they introduced liquidity. I do think March was absolutely a worst-case scenario, no doubt. Fortunately we only had to live through that for about a week or so — but it was a scary time.”