When Markets Go Bonkers, Bond ETFs' Underlying Structures Can Trip Investors Up

The idea behind exchange-traded funds is that they are a no-frills, simple way for investors to track the performance of particular stocks or other assets. There is a problem with how they work when the assets in the basket are not easily tradable, especially during times of market turmoil when the assets in the basket aren't easily tradable.

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Among the many options available to investors, the SPDR S&P 500 ETF Trust SPY –0.05% (ticker: SPY), which tracks the S&P 500 SPX –0.05%, one of the most liquid, high-profile, and transparent indices on earth, is at the very simple end of the spectrum. In contrast to this, there is a growing ETF market of $1.3 trillion in the bond market.

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By taking a closer look at some of the basic components of plumbing, it is easier to understand what could go wrong.

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The shares of an ETF are traded on an exchange like stock shares, unlike open-end mutual funds, which are traded on the market as a whole. In theory, the price of the ETF should be matched or very close to its net asset value, or NAV, in most cases.

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This can be managed with the help of a special mechanism that is built into ETFs. Authorized participants, often large financial institutions such as banks, play a crucial role in the operation of the system.

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An authorized participant, or intermediary, can buy fund shares on the market when there are more sellers than buyers of an ETF, and then redeem the shares in exchange for what's called a redemption basket when there are more sellers than buyers, according to a recent academic paper published in The Journal of Finance. In the case of a fixed-income ETF, the intermediary has the ability to liquidate the bonds in the basket on the open market, in accordance with the paper titled, “Steering a Ship in Illiquid Waters: Active Management of Passive Funds.”

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Stock prices are supported by a decline in fund shares.

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An authorized participant can obtain shares of the ETF in return for bringing cash to the sponsor of the fund, or bringing a stack of the securities that make up the creation basket when there are more buyers than sellers. This can result in a decrease in the price of the fund since those shares can be sold.

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In the long run, this mechanism serves as a way of ensuring that the price and NAV of the ETF are aligned if taken in its entirety.

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The ease and speed with which something can be exchanged, or the liquidity of the process, adds a degree of complexity. There are large volumes of shares in the S&P 500 that are traded every day, so it is easy for authorized participants to buy or sell them easily.

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Compared to stocks and shares, bonds are significantly less liquid, which is why bond ETFs are a far better choice than trying to buy and sell thousands of securities that can be contained within bond indices. An ETF is usually tracking a subset of the bonds in the index it is tracking, and not the entire index itself when it creates a security basket that contains the subset of bonds.

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However, by taking that approach, the ETF attempts to balance the benefits of liquidity, particularly a smaller basket of bonds, "with the costs associated with imperfect index-tracking," as outlined in the paper.

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“It is essentially a way of increasing liquidity at the end of the day by directing the creation/redemption basket into the most liquid underlying bonds," explains Bryan Armour, director of passive strategies research at Morningstar. There are a large number of bonds that don't trade every day, according to him.

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In times of market stress, Zeng, a Wharton School professor, says that prices and net asset values may diverge widely when a market is experiencing stress.

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During the recent Covid-19 pandemic, an example comes to mind from recent memory. IGSB -0.07% (IGSB) closed at $48.16 on March 20, 2020, a discount of nearly 4% against its net asset value of $50.16 on that date. This represents a discount of nearly 4% to its closing price of $48.16 on March 20, 2020.

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As a result of this, the gap between the fund's price and its net asset value quickly closed. Investors, however, would have taken a substantial loss if they had sold their fund shares at that time if they had sold them.

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BlackRock's Steve Laipply, global co-head of iShares Fixed Income ETFs, pointed out that an investor holding a fixed-income portfolio of bonds like those in the iShares ETF on their own account would also have had trouble selling without a loss. According to him, it would be extremely difficult to liquidate those bonds at anything close to the NAV if you wanted to liquidate them.

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As the authors assert in their paper, what happened in the bond market was that acute selling pressure led to the redemption of bond ETFs, which in turn strained the liquidity of bonds consolidated into redemption baskets, which was a result of acute selling pressure in the bond market. “There is a reasonable chance that future episodes of ETF-induced liquidity strains will occur in the future,” the paper stated.

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There are also concerns raised by the finance professors that, in times of financial stress, authorized participants are becoming reluctant to take on more bonds of a particular kind if they have already taken on a certain amount of those bonds through baskets. This scenario could lead to deterioration of the liquidity of those bonds under that scenario. As Zeng points out, "bonds included in redemption baskets may become disproportionally less liquid as compared to bonds excluded from such baskets.". 

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Laipply, however, does not see it in the same way. “It is not compulsory for authorized participants to participate in either creations or redemptions,” he explains. “They do creations and redemptions when it makes economic sense for them to do so and when it is feasible for them to do so."

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In regard to those baskets that represent only a subset of an index that a bond index ETF tracks, Laipply told us that at BlackRock, the more redemptions we saw over time, the wider the baskets got over time in order to maintain the tracking profile of the index.

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As he argued, bond ETFs can serve as valuable tools to help bond investors understand how to bond securities are trading at a given point in time, even if there is a considerable discount to NAV. “It is important to understand that you are watching a real-time basket price that is being calculated perhaps tens of thousands of times a day in real-time as the trades take place on the exchange,” he explains.

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Although there is a lot of functionality in a bond ETF, it is not as complicated as it is in a stock ETF. Markets can suffer from a lot of financial stress when they come under a lot of pressure.

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"We really want to make sure that retail investors are informed about the mechanisms that are used to trade bond ETFs," Yang said. "Most [ETF] retail investors are thinking about the S&P 500 index when they think about investing in ETFs."