Why Asset Managers Should Reconsider Bond ETFs in the Coronavirus Economy

Fixed income ETFs are not often in the news. With both fixed income assets and ETFs known for their stability compared to more volatile assets, fixed income ETFs have mostly been utilized by asset managers to bring the stability of bonds to a portfolio without the resources to actively manage a bond portfolio. However, the volatility of the economy due to coronavirus has changed the dynamic of these assets.
As coronavirus-induced volatility drives scarce liquidity across the fixed income spectrum, bond ETFs are becoming difficult to price. In a period of low volatility, these ETFs are priced in line with underlying securities. During times of high volatility, the liquidity premium of trading the ETF is increased and outweighs the liquidity premium of the underlying securities. Fixed income ETFs can be used by investors as a safe place to invest cash over a period of time or as a substitute to owning individual bonds in a portfolio. However, investors should be aware of how volatility affects the fixed income ETF.
 

Investing in ETFs Historically Provided Stability & Diversity

ETFs typically offer a low cost way to gain diversified, liquid exposure. Many investors use fixed income ETFs as an alternative to buying and holding individual bonds to gain the same exposure, but with greater liquidity. Unfortunately, this rationale fails to capture how ETFs perform during periods of increased volatility. With increased uncertainty and volume, there is a mismatch between the “equity-like” liquidity and the actual liquidity of buying and selling bonds.
 

Effect of the ETF NAV in a Volatile Market

The fixed income ETF investor experiences large swings in trading volume and is forced to realize losses when credit spreads and liquidity premiums are elevated. ETFs are currently selling illiquid positions at realized prices far below what the fund estimated the underlying securities would be worth. That’s why the NAVs of fixed income ETFs plummeted last week far below what would have been suggested by credit risk alone.
With inflows and outflows, ETF managers are forced to purchase or sell bonds at current yields. Prior to rates being slashed to zero, investors should have benefited from higher coupons as the NAV should appreciate in value. The large volume of ETF flows will reduce that benefit and a long-term investor will yield more in-line with the current yield rather than the yield when they first chose to invest.
 

Rethinking Fixed Income ETFs as an Investment Strategy

The current liquidity crunch is making it abundantly obvious that fixed income ETFs are not the best option for long-term investors. Why is this shifting dynamic leading investment managers to reconsider fixed income ETFs?

• ETFs trading at high discount levels: The liquidity mismatch and large fund flows have been evident across the past few weeks. Heading into Friday, roughly 70 fixed income ETFs were trading with at least a 5% discount to their NAV, and 16 traded at a discount of 10% or greater.
• ETFs offer limited flexibility: An ETF investor doesn’t choose the underlying securities, which limits the ability to extend/reduce duration, credit quality, or liquidity.
• ETFs have no maturity insight: During times of market volatility, owning an individual bond has the benefit of being held to maturity compared to an ETF, which has no maturity date. There is no guarantee that after a market event, an ETF will ever get back to par value.

Technology Enables Owning Underlying Bonds

Long-term investors looking for fixed income exposure should own the underlying bonds, not ETFs. Asset managers can then choose to hold to maturity and reinvest the cash or they can sell the securities at any given time. Traditionally, separately managed accounts (SMAs) have been a costly and resource-intensive endeavor. Not surprisingly, these accounts often carried large account minimums. Investment management technology is changing the manual effort required to manage a large number of bond SMAs effectively.
While the economy is still evolving from the effects of coronavirus, managers are learning from the current volatility and liquidity crunch. Though fixed income ETFs have historically provided easy access to diversity and stability in the bond market, investors need to be better prepared for future volatility by owning individual bonds.
 
 
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