The fastest bear market decline ever and accompanying disruptions in credit markets in March provided a tough test for exchange-traded funds (ETFs). With a big assist from the Federal Reserve (Fed), which announced it would purchase fixed income ETFs, and increasing optimism around an economic rebound, fixed income ETFs seem to be functioning normally again.
In a period of extreme uncertainty, with a recession almost certainly underway, big swings in stocks and economically sensitive bonds are to be expected. But the swings in high-quality bond ETFs stocked with government bonds, including short maturities, was surprising. On March 12, 2020, for example, the biggest and broadest core bond products from the biggest issuers (Vanguard, BlackRock, State Street, and others), lost between 4% and 6%. Even short-duration, high-quality fixed income products saw huge, atypical down moves. Interest rate volatility and potential credit losses can’t explain all of these moves.
What else was going on? The answer is liquidity dried up. There are a lot of market makers trading SPY, QQQ, IWM, Apple, and Microsoft. But in times of stress, with fewer buyers readily available in more thinly traded securities, bid-ask price spreads widen and prices reported at the end of the trading day can swing more wildly. Some bonds held by these fixed income products don’t have any bids during times of market stress (that goes for mutual funds and ETFs, by the way).
This is where ETFs play a role as providers of price discovery. Without any bids (or transactions) in certain bonds, market makers in conjunction with their data partners have to estimate values. But without the ETFs, there would be no estimates. So even though market prices can disconnect from net asset values (NAV), ETF prices should generally be timelier and more accurate. Also keep in mind that this can also lead to identical portfolios with different wrappers sometimes trading at different prices.
Perhaps the best news is ETFs seem to have passed the test. Some widely-held fixed income ETFs are even trading at premiums to their NAVs after the Fed announced it would be involved and the market bid up prices. For those using these products, we would continue to do so. LPL Research still believes in the structure. Our advice now would be watch premiums/discounts to NAV and use limit orders to improve your execution on trades. Midday orders generally work better than orders at the beginning or end of the trading day.
More broadly, despite near record-low yields, we would continue to use fixed income for portfolio diversification. Clearly bonds were a big help in March in offsetting stock market losses.
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An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
Exchange-traded-funds (ETFs) offer shares that trade in the secondary market. Because ETFs are listed on exchanges, individual ETF shares can be bought and sold throughout the trading day at the current market price. The general level of stock or bond prices may decline, thus affecting the value of an equity or fixed income exchange traded fund, respectively. Moreover, the overall depth and liquidity of the secondary market may also fluctuate. Therefore, value of the shares, when redeemed, may be worth more or less than their original cost. Due to market conditions, ETF shares trading on the exchange may be available for purchase at a premium or discount to NAV.
Bonds subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
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