3 ms·

Well, stupid question then: why would this prop up the debt market? They're just buying tokens redeemable[1] for a basket of bonds. How does that prop up (the u

by SilasX 7y ago

Well, stupid question then: why would this prop up the debt market? They're just buying tokens redeemable[1] for a basket of bonds. How does that prop up (the underlying) bond prices? Or their liquidity? ETF prices are pretty firmly anchored to the underlying bond basket prices, due to arbitrage, so prices only flow from the bonds to the ETF shares, never the other way around. Is there a dynamic I'm missing whereby the purchase of ETFs make the bonds more valuable on the market? For an analogy, let's say there are coupons you can redeem for a 20-lb turkey at Trader Joe's (analogous to bond ETFs, which are redeemable for baskets of the underlying). Let's say they trade on a secondary market (like those coupon selling sites) at a stable discount to the market price of the turkeys at TJ's. Let's say I go out and start buying up the coupons with reckless abandon. I accept that they would then trade at a smaller discount to TJ turkeys. But why would that raise the market price of the turkeys themselves? Nothing about that makes the turkeys themselves more in-demand, does it? [1] which is how I understand ETFs to work and maintain value parity

whatok 7y ago
There's a few faulty assumptions that might apply to more liquid and efficient markets but do not apply to corporate bonds. Corporate bond liquidity is minuscule and many create/redeems are done with incomplete baskets vs actual underlying. One of the reasons why the Fed decided to include ETFs in this facility is because the ETFs were trading at a steep discount to NAV at some points earlier this year. For example, SPY's largest discount to NAV this year was around 80bps. For LQD (the largest and most liquid IG ETF), the largest discount was close to 5.1%. Discounts to NAV of that size are not academically arbed away with illiquid underlying assets because there's no liquidity or price discovery happening in those assets either.
- SilasX 7y ago
  Okay but that doesn't address why buying up the ETF would bid up the underlying, it just shows that a discount against NAV exists and Fed intervention could shrink it (just as my intervention could in my turkey example). Alternatively, the goal could be to do nothing about the 80 bps or whatever discount, but keep it the same while pushing up ETF share price and NAV together ... but I don't see why this intervention would do that, either.
- rndmwlk 7y ago
  I want to preface my statements with this, I'm not trying to get into an internet argument or attack your positions or anything I'm just trying to learn some stuff here because I find it all interesting. In the case of such poor liquidity why should we assume the ETF value should rise to meet the NAV rather than the NAV lower to meet the ETF value? I understand the bonds are the underlying here, but if the ETF is more liquid wouldn't its value be closer to gospel?
  - whatok 7y ago
    Your thought pattern makes sense but a lot of dislocations in these markets are once again due to liquidity. I think the easiest way to summarize this is because of the liquidity transformation ETFs provide, the tail wags the dog until it doesn't. This gets a bit rambling but I am too lazy to edit right now. Liquid hedges are extremely valuable when trading corporate bonds. With almost every sell-off/rally, you will see more liquid instruments be first movers and usually overshoot in either direction. If I wanted to buy/sell 100mm MV of bonds right now, I would have to pay through the nose and there's no dealer on earth (due to post-GFC regulations) that is warehousing 100mm MV of a single bond issue so then I'm probably buying 10-20 different bonds and that doesn't really fit what I'm trying to do. Instead, I can buy/sell 100mm of a bond ETF, pay close to equity-like bid/ask spreads, and do so without picking up the phone or having someone decline to trade with me. I'm a little braindead right now and I know this is a bad example but this makes intuitive sense: if I really need cash immediately for something, I'll go to the pawn shop first before going to the bank. The pawn shop will give me immediate liquidity while the bank might not be open, want me to open an account, fill out some documents, blah blah. The same thing happens with SPY, if I want to hedge my up/downside and need to do it quickly and efficiently, buying/selling single name equities in a lot of cases is not the best way to proceed. Dislocations vs NAV rarely happen with SPY or anything with large liquid underlying assets because the create/redeem process for these is very efficient; I can do it through an API. There have been advances in the corporate bond market but for the most part bonds are traded via chat or phone. So, let's say bonds sell off for whatever reason, everyone immediately reaches for an ETF rather than selling any bonds. The underlying market takes some time to react and there's a further cascade of price discovery that usually happens in order of liquidity. When you have several thousand bonds underlying an ETF and no efficient way to trade them, price discovery takes a while. ETF overshoots, bonds try to catch up, oh but wait now this bond looks cheap/rich vs that other bond, then maybe everyone starts taking their hedges off, and then the process restarts in a miniature fashion. This tug of war can take days to shake out but in the meantime, the create and redeem process still exists so if I feel the ETF is way too rich (simple unreaslitic example but "wow, ETF dividend yield is 5% but the underlying bonds yield 10%") I can buy some shares and redeem them for the underlying bonds and also do the reverse. The create/redeem process was broken during the recent sell-off because there was no consensus on where NAV actually was. Sure, the ETF provider publishes a NAV level but you had several ETFs trading at several percentage point discounts. In normal cases, I can buy the ETF and redeem it for the underlying theoretically pocketing the difference. I'm not going to do that if the underlying price should be much lower or I'm just uncertain as to where it really should be. Long story short, ETFs track NAV closer in more efficient markets. In less efficient markets, ETFs or any liquidity transformation vehicle usually lead the underlying because it's easier/cheaper to transact in them. From there it's price discovery on the underlying which happens at varying speeds and the process goes back and forth.

by SilasX 7y ago

whatok 7y ago

There's a few faulty assumptions that might apply to more liquid and efficient markets but do not apply to corporate bonds. Corporate bond liquidity is minuscule and many create/redeems are done with incomplete baskets vs actual underlying. One of the reasons why the Fed decided to include ETFs in this facility is because the ETFs were trading at a steep discount to NAV at some points earlier this year. For example, SPY's largest discount to NAV this year was around 80bps. For LQD (the largest and most liquid IG ETF), the largest discount was close to 5.1%. Discounts to NAV of that size are not academically arbed away with illiquid underlying assets because there's no liquidity or price discovery happening in those assets either.

SilasX 7y ago
Okay but that doesn't address why buying up the ETF would bid up the underlying, it just shows that a discount against NAV exists and Fed intervention could shrink it (just as my intervention could in my turkey example). Alternatively, the goal could be to do nothing about the 80 bps or whatever discount, but keep it the same while pushing up ETF share price and NAV together ... but I don't see why this intervention would do that, either.
rndmwlk 7y ago
I want to preface my statements with this, I'm not trying to get into an internet argument or attack your positions or anything I'm just trying to learn some stuff here because I find it all interesting. In the case of such poor liquidity why should we assume the ETF value should rise to meet the NAV rather than the NAV lower to meet the ETF value? I understand the bonds are the underlying here, but if the ETF is more liquid wouldn't its value be closer to gospel?
- whatok 7y ago
  Your thought pattern makes sense but a lot of dislocations in these markets are once again due to liquidity. I think the easiest way to summarize this is because of the liquidity transformation ETFs provide, the tail wags the dog until it doesn't. This gets a bit rambling but I am too lazy to edit right now. Liquid hedges are extremely valuable when trading corporate bonds. With almost every sell-off/rally, you will see more liquid instruments be first movers and usually overshoot in either direction. If I wanted to buy/sell 100mm MV of bonds right now, I would have to pay through the nose and there's no dealer on earth (due to post-GFC regulations) that is warehousing 100mm MV of a single bond issue so then I'm probably buying 10-20 different bonds and that doesn't really fit what I'm trying to do. Instead, I can buy/sell 100mm of a bond ETF, pay close to equity-like bid/ask spreads, and do so without picking up the phone or having someone decline to trade with me. I'm a little braindead right now and I know this is a bad example but this makes intuitive sense: if I really need cash immediately for something, I'll go to the pawn shop first before going to the bank. The pawn shop will give me immediate liquidity while the bank might not be open, want me to open an account, fill out some documents, blah blah. The same thing happens with SPY, if I want to hedge my up/downside and need to do it quickly and efficiently, buying/selling single name equities in a lot of cases is not the best way to proceed. Dislocations vs NAV rarely happen with SPY or anything with large liquid underlying assets because the create/redeem process for these is very efficient; I can do it through an API. There have been advances in the corporate bond market but for the most part bonds are traded via chat or phone. So, let's say bonds sell off for whatever reason, everyone immediately reaches for an ETF rather than selling any bonds. The underlying market takes some time to react and there's a further cascade of price discovery that usually happens in order of liquidity. When you have several thousand bonds underlying an ETF and no efficient way to trade them, price discovery takes a while. ETF overshoots, bonds try to catch up, oh but wait now this bond looks cheap/rich vs that other bond, then maybe everyone starts taking their hedges off, and then the process restarts in a miniature fashion. This tug of war can take days to shake out but in the meantime, the create and redeem process still exists so if I feel the ETF is way too rich (simple unreaslitic example but "wow, ETF dividend yield is 5% but the underlying bonds yield 10%") I can buy some shares and redeem them for the underlying bonds and also do the reverse. The create/redeem process was broken during the recent sell-off because there was no consensus on where NAV actually was. Sure, the ETF provider publishes a NAV level but you had several ETFs trading at several percentage point discounts. In normal cases, I can buy the ETF and redeem it for the underlying theoretically pocketing the difference. I'm not going to do that if the underlying price should be much lower or I'm just uncertain as to where it really should be. Long story short, ETFs track NAV closer in more efficient markets. In less efficient markets, ETFs or any liquidity transformation vehicle usually lead the underlying because it's easier/cheaper to transact in them. From there it's price discovery on the underlying which happens at varying speeds and the process goes back and forth.