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Don't Fight The Fed?

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This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Mark Abssy, founder of ETF consulting firm All You Can ETF LLC.

Recent dislocations in fixed income markets have prompted unprecedented actions by the Federal Reserve to support fixed income markets including investment-grade corporates, below-investment-grade corporates or “junk” bonds and most recently, municipal bonds.

The majority of those dollars were earmarked for direct investment into supporting existing issues and new issuance, but allocations were also made for direct investment in exchange-traded funds. One recent edict states the Fed is permitted to hold up to 20% (!) of targeted high yield ETFs.

Part of the impetus for this move is that bonds simply weren’t trading and as a result, stale prices were being captured by ETF (and mutual funds’) net asset value (NAV) calculations resulting in stale NAVs for a number of fixed income funds. While NAVs were being mispriced the funds themselves were still trading and unsurprisingly trading away from their underlying portfolio values.

Misplaced Anxiety

I’m confused as to the hand-wringing/pearl clutching regarding fixed income ETFs trading away from NAVs. The ETF marketplace is no stranger to funds trading away from posted NAVs. The 2011 “Arab Spring” prompted a 55-day shutdown of Egyptian equity markets that saw the VanEck Vectors Egypt Index ETF (EGPT) trade significantly away from its last posted NAV.

Due to an administrative oversight, the United States Oil Fund LP (USO) once traded to as much as a 17% premium due to strong demand and a fixed share amount. EGPT came back in line (ETF share price traded down to NAV) after Egyptian equity markets re-opened and USO traded back to NAV once additional shares became available.

Indeed, the creation/redemption process was developed specifically to facilitate share price stability relative to NAV and once these underlying markets are stabilized, that process can proceed and ETF prices will come back in line.

The solution to this issue is to get as many prints as possible on as many underlying securities as possible, as the Fed has been active in these markets. My naive question is why do we need trillions of dollars to get good bids in these underlying markets? Further, why the focus on buying ETF shares?

ETF share prices are the tail of the underlying security valuation dog. Manipulating ETF share prices to conform to stale/incorrect NAVs is a waste of resources all around. It serves to treat symptoms and not address the underlying problem.

Better Way?

It seems to me that a simple and less onerous solution would be to have the Fed purchase enough shares to facilitate one redemption basket (this should be doable in regular trading, no creation required). They then redeem that basket in-kind. The second part of the process involves creating a buying group composed of major buy-side fixed income shops.

The rationale here is that many shops specialize in particular areas of fixed income, and more importantly are oftentimes the ones marking their own positions (per regulatory approval). Those shops would constitute a committed buyer pool that would price and purchase those underlying bonds (financed by the Fed). Those trades get reported (Bloomberg, TRACE, MarketAxess, etc.), and NAVs in turn print valid prices.

What would be interesting to see is the execution of this Fed action be a catalyst to finally drag corporate bond trading out of the “relationship age” and into the “information age.” 

There have been a number of advancements over the years around pre- and post-trade activities, but from conversations I have had with fixed-income traders it seems corporate trading today looks a lot like off-exchange equity trading from the early 2000s with crossing networks prominently featured. What will it take to move this activity on to an exchange?

Barriers To Electronic Bond Trading

Some people maintain that a potential impediment to moving corporate trading on exchange is the sheer size of the market. According to the Securities Information and Financial Markets Association (SIFMA), there was approximately $9.5 trillion worth of outstanding US corporate debt at the end of 2019. As a testament to the opacity of this market it is a little difficult to find a good figure for number of issuers (roughly 3,400 by my ability to read Chart 2 in a Standard & Poor’s research paper).

Using the ICE Global Corporate and High Yield Index as proxy there are approximately 20,000 issued and outstanding bonds. Let’s assume there’s a long tail in that distribution and the actual number is, say 30,000 or even 40,000. There are about 4,000 U.S-listed equities so how can it be possible to scale that infrastructure to accommodate all those bonds?

Enter the U.S. options market. Every trading day continuous two-sided markets are made on over 700,000 contracts, including complex order types and cross-exchange order routing for best execution, among other innovations.

At a high level creating the physical and digital infrastructure for this new market would be relatively easy. Closer to the ground it would be really messy. Good news is there wouldn’t be one line of COBOL in the entire thing.

Mark Abssy is the founder of All You Can ETF, LLC, and can be reached at [email protected]tf.com.

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