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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 minuscul

by whatok 6y 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 6y 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 6y 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 6y 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.
  - rndmwlk 6y ago
    >This gets a bit rambling but I am too lazy to edit right now. No worries, as I said I'm interested so I appreciate the write up. >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. Totally get this relationship, that's not entirely where my question lies though. >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. So is the Fed just buying these ETFs in order to shore up this discount regardless of whatever they believe to be "true" NAV? Why would the Fed consider it important enough for intervention? Or are they really just at a point where they're truly raising the tide and this boat is getting more publicity?
    - whatok 6y ago
      There's a few reasons. The Fed's mandate to "promote maximum employment" has taken the form of ensuring properly functioning capital markets. ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument. Lack of effective hedges increases volatility in markets and forces investors to reduce positions. Further reducing positions during a sell-off causes an even steeper sell-off, etc blah blah. Additionally and more importantly, primary market transactions are priced off secondary market levels. During the sell-off and before the Fed intervened, corporate bond issuance completely vanished. A large portion of US companies are debt-financed and would be unable to finance operations or be forced to pay way higher rates without functioning debt markets. Ensuring both the primary and secondary market functions properly fulfills (in their theory) their mandate of promoting maximum employment because without either, a lot more companies would have gone under or laid off way more people.
      - rndmwlk 6y ago
        >ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument. Sure, but that's only if we consider NAV to be "true" worth. To your point with the lack of liquidity in the underlying wouldn't logic dictate that the underlying needs to "catch up" so to speak?

by whatok 6y ago

SilasX 6y 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 6y 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 6y 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.
- rndmwlk 6y ago
  >This gets a bit rambling but I am too lazy to edit right now. No worries, as I said I'm interested so I appreciate the write up. >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. Totally get this relationship, that's not entirely where my question lies though. >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. So is the Fed just buying these ETFs in order to shore up this discount regardless of whatever they believe to be "true" NAV? Why would the Fed consider it important enough for intervention? Or are they really just at a point where they're truly raising the tide and this boat is getting more publicity?
  - whatok 6y ago
    There's a few reasons. The Fed's mandate to "promote maximum employment" has taken the form of ensuring properly functioning capital markets. ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument. Lack of effective hedges increases volatility in markets and forces investors to reduce positions. Further reducing positions during a sell-off causes an even steeper sell-off, etc blah blah. Additionally and more importantly, primary market transactions are priced off secondary market levels. During the sell-off and before the Fed intervened, corporate bond issuance completely vanished. A large portion of US companies are debt-financed and would be unable to finance operations or be forced to pay way higher rates without functioning debt markets. Ensuring both the primary and secondary market functions properly fulfills (in their theory) their mandate of promoting maximum employment because without either, a lot more companies would have gone under or laid off way more people.
    - rndmwlk 6y ago
      >ETFs not getting too dislocated from NAV is an important part of that because otherwise they become a useless hedging instrument. Sure, but that's only if we consider NAV to be "true" worth. To your point with the lack of liquidity in the underlying wouldn't logic dictate that the underlying needs to "catch up" so to speak?