BLK BlackRock Inc

By Dawn Lim 

A broad set of bond exchange-traded funds are trading out of sync with their underlying assets, testing investors' faith in a fast-growing part of the investment world.

Bond ETFs of BlackRock Inc., Vanguard Group and others traded at historic discounts to the net asset value of their underlying bonds in recent days. The iShares iBoxx USD Investment Grade Corporate Bond ETF closed down at a discount of over 5% late last week, a record since 2008. The $28 billion bond fund, with the ticker LQD, typically trades within a fraction of a percentage point of the bonds it is designed to track. It closed at a discount of over 1.5% every day of the past week.

The discrepancies expose the most dramatic mismatch in years between the liquidity promised by many ETFs and their underlying bonds. Liquidity is the ease at which investors can cash out of assets without sacrificing gains. While ETFs trade like stocks on exchanges, the spreading coronavirus pandemic has snarled bond trading and made securities from junk bonds to Treasurys harder to price.

The abnormal gap is reigniting a debate about the resilience of the ETFs if there is a prolonged rout. Investors pulled some $20 billion in net money from U.S. bond ETFs in the first few days of the past week.

"Bond ETFs are promising perfect liquidity in markets that are over-the- counter and have ad hoc, not instantaneous, liquidity," said Sonal Desai, chief investment officer of the fixed-income group at Franklin Templeton Investments. "They now face a fairly critical test."

The invention of the ETF allowed millions of investors to trade entire markets almost instantaneously. Bond ETFs, which surpassed $1 trillion in assets last year, are used by everyone from the smallest day traders to the biggest sovereign-wealth funds.

The Vanguard Total Bond Market ETF, with the ticker BND, is one of the world's largest such funds, with more than $50 billion in assets. It traded at its biggest ever discount to net asset value -- 6.2% -- earlier this month. It pared back the discount but still traded at a larger-than-average discount to net asset value in the past week.

Bond ETFs have always been susceptible to moving out of step with their underlying investments because bonds trade more infrequently, making it difficult for bond pricing services to calculate their latest values.

Some say the liquidity mismatch highlights the fragility of bond funds and raises questions about whether investors are getting a fair price. Others say the ability of ETFs to house less-liquid securities within a tradable wrapper attests to their importance when news moves faster than trading in other markets can keep up.

"You're getting a lot of information -- real-time information -- being transmitted by the ETF about conditions in the bond markets," said Samara Cohen, BlackRock's co-head of iShares markets and investments. "Markets and bonds aren't trading fast enough to validate or invalidate the information."

The Securities and Exchange Commission has regular check-in conversations with asset managers to assess the quality of the trading ecosystem around ETFs. In recent weeks, the agency's officials have been asking if the mechanisms that allow ETFs to trade in line with their underlying asset values are functioning as they should, said people familiar with the matter.

The majority of ETF trading involves existing ETF shares changing hands on exchanges. But behind the scenes, an army of Wall Street traders carries out a different kind of trade just as critical to the orderly functioning of the $6 trillion ETF industry.

Each day, bank intermediaries and other middlemen buy baskets of instruments to exchange for shares of ETFs, or vice versa, to profit from price differences. Those trades keep ETF prices in check with their underlying investments and essentially prevent those funds from turning into closed-end funds.

It is more challenging doing that trade in choppy markets.

Traders and investors say bank credit desks are losing confidence over how to price bonds and wrestling with how to price the toll of a pandemic with no precedent in modern history. As investors have scrambled to sell assets and unwind trades, correlations between financial instruments have broken down and liquidity has vaporized in parts of the bond market once seen as a haven.

When the BlackRock ETF with the LQD ticker fell to steep discounts to its underlying assets over the past month, BlackRock's Ms. Cohen got on call after call with various Wall Street intermediaries to rule out failures in the ETF. Wall Street traders told BlackRock that the ETF was tradable. The issue was that many of the underlying bonds weren't. That is how the fund was out of sync with the net asset value of its investments. Less than half of the bonds in that investment-grade corporate bond fund typically trade in a day.

"That spread is an indication of the increased difficulty of executing what should be a risk-free arbitrage," said Ken Monahan, who focuses on market structure and technology at research firm Greenwich Associates.

"The ETF complex is by no means broken," he added.

ETF traders say as long as there is a preponderance of buyers and sellers on exchanges, the market is fair.

In March, bond ETF trading made up a higher average daily share of equities trading compared with the average day last year, according to a Wall Street Journal analysis of the New York Stock Exchange data on U.S. exchange trading volumes.

At Vanguard, the average daily dollar volume of fixed-income ETFs trading in the first four days of last week was five times higher than the previous year's average.

"This is why ETFs are thought to be the vehicle for price discovery," said Rich Powers, Vanguard's head of ETF product management. "It's not to say it's the perfect price. There is no perfect price in the bond market."

In an acknowledgment that bond market liquidity is harder to find, Vanguard and BlackRock made it more expensive last week for some Wall Street intermediaries to get redemptions from certain bond ETFs in cash.

Write to Dawn Lim at dawn.lim@wsj.com

(END) Dow Jones Newswires

March 23, 2020 08:14 ET (12:14 GMT)

BlackRock (NYSE:BLK)
Historical Stock Chart
From Mar 2024 to Apr 2024

BlackRock (NYSE:BLK)
Historical Stock Chart
From Apr 2023 to Apr 2024