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Amid market turmoil spurred by pandemic concerns, investors increasingly turned to bond exchange traded funds (ETFs) for clarity about what was happening in fixed income markets and to actively adjust their portfolios. Recent evidence suggests that bond ETFs may reflect the conditions of the markets while improving price transparency and providing access to liquidity in periods of market stress.
Commentators have long speculated about what would happen should bond ETFs be tested by a once-in-a-generation market shock and raised questions about whether ETFs can withstand waves of selling. The facts from February and March 2020 show that ETFs held up well in extreme fixed income market conditions. Investors turned to the most frequently traded ETFs to help them navigate bond market dislocations. As they did so, these flagship ETFs often became sources of real-time price discovery for markets where transparent quotations and trading activity on the underlying bonds deteriorated.
As bond markets get more volatile, investors flocked to bond ETFs
As financial market volatility increased from late February through late March 2020, average daily trading volumes in all U.S. bond ETFs more than tripled to nearly US$35 billion, compared with US$11 billion last year.1
Trading in Australian bond ETFs listed on the ASX also experienced a similar rise in volume with daily trading in March 2020 nearly double the daily average in quarter 4 20192.
Investors tend to use bond ETFs even more during times of uncertainty because they are efficient and effective tools for rebalancing holdings, hedging portfolios and managing risk. Consider the following from the US ETFs market:3
- Daily trading volume in the frequently traded US denominated high yield corporate bond ETF; the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) surged to more than US$8 billion (compared with an average of US$1.7 billion in 2019) on the same day that the Cboe Volatility Index, or VIX, climbed to its highest level since 2011.
- By itself, HYG accounted for 27% of total high-yield bond market trading over this four-week period. That’s up from 14% in January.
Whether in HYG or other ETFs that seek to track bond indexes, the implication is clear: as markets became more volatile, investors flocked to bond ETFs.
As more investors turned to bond ETFs, they became indicators of real-time prices
Many bond ETFs trade frequently, meaning their prices incorporate more real-time information than even the most heavily traded bonds in the fund. This is especially true during volatile markets as ETF trading activity increases.
On March 12, one of the worst days for U.S. stock benchmarks in modern history, the flagship US denominated corporate bond ETF listed in the US; the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) changed hands almost 90,000 times on exchange, while its top five holdings traded an average of only 37 times apiece.4
From looking at the US market it is clear that mature fixed income ETFs regularly trade thousands of times more frequently than the bonds in their portfolios, a pattern that is magnified in volatile markets.
Each day ETFs are required to publish a net asset value (NAV) for the portfolio. For bond ETFs, the NAV value of the held bonds is based on both the last actual traded price and estimates based on trades of similar bonds from the same issuer or sector, or other market metrics. Unlike NAV, a bond ETF’s on-exchange price represents an actionable trade for that entire portfolio at that moment. This price can differ from NAV, particularly during periods of volatility and market stress.
Indeed, bond NAVs can at times resemble appraisals for a house, which are similarly derived from both real purchases/sales in the neighbourhood as well as estimates. As any homeowner knows, the difference between an appraisal price and the actual price can vary markedly: the price that matters is the one at which you can buy or sell.
When a bond ETF trades at a “discount” or a “premium” during volatile periods, the takeaway is often that ETFs offer real-time price indications much like actual prices for a house represent levels where real buyers meet real sellers.
Reduced trading in the bond market during a volatile March 2020
Bond trading/liquidity was constrained during March especially in corporate bonds, this can be seen on the chart below that shows the trading of the underling bonds within our flagship US denominated corporate bonds ETF; the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). The fact that 70% of the bonds traded less than 10 times a day provides context for this ETFs additional liquidity and price discovery for the asset class.
Source: FINRA TRACE, BlackRock from 3/2/2020 - 3/20/2020. Includes only end investor buys and sells - not dealer-to-dealer trades.
Bond ETFs have performed as expected
Investors ultimately use index-tracking bond ETFs to seek index exposure within their portfolio. iShares bond ETFs allowed investors to actively adjust portfolios, even in the face of extreme price volatility and limited trading in the underlying bond markets.
1 BlackRock, Bloomberg; ADV includes all U.S-listed bond ETFs from Feb. 24, 2020 through March 23, 2020 (data as of March 24).
2 BlackRock, Bloomberg, turnover from 18 ASX Australian Fixed income ETFs
3 BlackRock, Bloomberg (data as of March 24, 2020).
4 BlackRock, TRACE (as of March 12, 2020).
5 Citigroup, “The coming revolution in credit portfolio trading” (November 2019).
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