Although the coronavirus outbreak is primarily a health crisis, the impact left on the global economy and financial markets has been significant. Unemployment has surged while prospects of economic growth have dissipated. The current unprecedented scenario has led to substantial volatility within global financial markets.
The shock has been drastic across all asset classes, however, within the corporate bond market this has been particularly pronounced, despite bond investors being accustomed to very low yields for years. The widespread sell-off, although justified, led to a significant widening in spreads.
Liquidity, which was already thin in particular segments within the fixed income class, such as the high yield market, suffered a material reduction, impairing price discovery. Illiquidity arising from the latest run for cash has given way to deep dislocations within the corporate bond market. Not only were investor losses significant given the blurred outlook and mounting uncertainty, but mutual funds holding high yield credit strategies came under pressure as outflows significantly increased.
Rather than dumping direct credit names, which in all fairness, selectively, were being indiscriminately valued, investors opted for exchange-traded funds (ETFs) to both manage risk and obtain real-time valuations.
ETFs are financial instruments designed to track the performance of an underlying index. Contrary to some of the assets being tracked, notably corporate bonds which may be less liquid and traded over-the-counter (OTC), similar to equities ETFs trade on regular stock exchanges, offering immediate liquidity.
The added liquidity posed by ETFs last month proved to be crucial for investors tracking the high yield credit market. Because of this added liquidity benefit, especially pronounced in times of crisis, the prices of ETFs tracking the performance of a suite of corporate bonds incorporated more real-time information than even the most heavily traded bond portfolio.
This portrays the power of ETFs as a price discovery tool. Due to the added liquidity, differences between bond ETF prices and net asset value (NAV) arise and thus result in discounts – ETFs trading at prices below their NAV. The NAV discounts that opened up within the bond ETF market in mid-March 2020, during the peak of recent turbulent market conditions, highlighted the fact that in challenging times, ETF prices react to new information in a timelier manner than NAVs do.
To clarify things, the NAV is an estimate of the fair value of the underlying holdings, based on actual trades of a bond portfolio. Meanwhile, ETF prices portray what investors are willing to pay. Notably, in mid-March, some of the largest ETFs, in both the investment grade and high yield space recorded NAV discounts above five per cent. Discounts to NAV were big in both the U.S. and European markets. The dislocations were indeed more pronounced in US investment-grade ETFs, possibly due to being oversold by investors in need of cash, and European high yield, whose underlying bonds lacked the support of the ECB’s Corporate Sector Purchase Program (CSPP).
As conferred, the market stress in mid-March highlighted differences in how quickly ETF prices and NAVs incorporate information. Given that ETFs, unlike mutual funds whose assets are valued once a day, trade continuously, they may serve as a useful tool for both market monitoring and as a risk management tool.
With regards to the latter, the Bank for International Settlements in a recent report stated that “the real-time nature of information makes ETFs a more suitable input in risk management models and regulatory capital calculations than stale NAVs”.
Despite the aforementioned advantages, ETFs in our view also pose disadvantages which do impact particularly the fixed income segment more pronouncedly. One of the more plausible negatives is the fact that ETFs usually do not hold any cash. As the ETF is faced with redemptions it has no option but to hit bids at any levels to raise the necessary cash. In turn, this will amplify the moves in direct names which will be hit harshly and possibly indiscriminately.
Due to the latter, we highly encourage investors that before investing, they understand the dynamics behind such instruments and the benefits of being invested in an actively managed mutual fund. The active rather than a more passive approach possibly offers more comfort in terms of mitigating downward trends.
Undoubtedly, in these current unprecedented times, active management should be the more rational decision.
Disclaimer: This article was issued by Christopher Cutajar, credit analyst at Calamatta Cuschieri. For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.