Fixed-Income ETFs Are Trapped in Bond Market’s Liquidity Crunch

As fixed-income markets buckle under wild swings and scarce liquidity, the strain is starting to show in bond exchange-traded funds.

Cash prices in some of the most actively traded bond funds are now at steep discounts to the value of their underlying assets. The largest debt ETF -- the $74 billion iShares Core U.S. Aggregate Bond fund -- closed at a 4.4% discount to its net asset value on March 12, the largest divergence since 2008, according to data compiled by Bloomberg. Meanwhile, the $31 billion iShares iBoxx $ Investment Grade Corporate Bond ETF’s price fell 5% below its net-asset value on Thursday, also the largest discount since 2008.

The havoc is reigniting arguments around fixed-income ETFs, which trade much more liquidly than the assets they hold. Critics have long warned the products were a pressure point that would crack in volatile times, as investors rush to redeem their holdings during a sell-off. But just as many arguments exist that ETFs give participants in less-active markets better prices in times of stress -- and an exit route.

“The ETF at least gives you some way to get out if you need to. you’re going to pay up for it, but if you have to get out, at least there’s liquidity somewhere,” said Eric Balchunas, senior ETF analyst at Bloomberg Intelligence. “The distance between the ETF and the NAV provides a great measure of the liquidity in the underlying market.”

Rampant turbulence across bonds markets is souring appetite for the arbitrage opportunity that normally keeps ETF prices in lockstep with a fund’s value. Normally, middlemen known as authorized participants will buy shares of a falling ETF in order to exchange for the underlying bonds with the fund’s issuer. That market maker will then sell those securities to pocket a virtually risk-free profit. The ETF’s price usually snaps back to the fund’s net-asset value as the supply of ETF shares is reduced.

But fear over the coronavirus’s economic fallout has unleashed historical volatility in fixed income, making it harder to unload the underlying bonds. As a result, the ETFs are trading at persistent discounts as thin liquidity sidelines market makers.