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ETFs played hero's role during liquidity crunch

29 May 2020 | Markets and economy

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Transcript

Tim Buckley: John, if we go back to the mid-to-end of March, there was an incredible liquidity crunch going on. We had a number of institutions moving towards cash. They all wanted to move towards T-bills. Investors were repositioning their portfolios. They needed liquidity. I would say that the bond ETF was a hero in this market. It provided so much of this liquidity, allowing people to reposition their portfolios.

So first, would you agree with that? Second, there was some criticism—well, why were they selling at a discount? Maybe you could explain where these discounts come from and whether people should be worried about them?

John Hollyer: Sure, Tim. Yeah, I agree that the bond ETF really shone during the bond crisis of the COVID period of March. And I think it's important to help people understand the context of what a bond ETF is and how it differs from the bond market.

In March, bank dealers, the market-makers with constrained balance sheets, had trouble helping buyers and sellers meet, and taking bonds onto their balance sheet to facilitate that, because their capital was constrained. ETFs are different. An ETF takes hundreds or even thousands of individual bonds and consolidates them into one standardized trading unit that trades on an exchange with a lot of transparency.

We saw during that time that bond ETFs traded in a quite liquid way and helped buyers and sellers add bond market risk or get rid of bond market risk, depending on their portfolio needs, and did it in a way that was more liquid than where the bond dealers have to buy individual bonds and put them on their balance sheet.

Tim: John, I want to stop you right there. People often don't realize that 90% of the trading with the ETF is done in the secondary market. It's just buyers and sellers meeting. Actually, those shares never come back to us at all. So the underlying bonds don't trade.

John: That's right. And it really makes that ETF more like a stock. It's highly concentrated. The stock of IBM is highly concentrated. There's one of them. These bond ETFs concentrate that trading, which makes it a lot more liquid and standardized.

Now, we've seen in some ETFs a discount, meaning that the market price of the ETF was below the net asset value of the shares. And that's really the price of liquidity. What's happening in those cases-- and it's particular to parts of the bond market that have less available hedging instruments, the kinds of things that a market maker or other dealer would use to offset the risk of buying the ETF shares or selling them-- it's pretty common in the muni market, where there aren't really good hedging instruments.

And so what you see, particularly in times of stress in the market, the price of liquidity rises. And that typically shows up in a larger discount of the market price of the ETF relative to the NAV. It's really the price of liquidity. And we find that as markets return more to normal, those discounts also come to normal. ETF investors have to realize that if they choose to trade, particularly to sell, during a time when the market's under stress, they're likely to pay a price for that liquidity.

Important information:

The information contained herein does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Diversification does not ensure a profit or protect against a loss.

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