BlackRock research pushes back at concerns over bond ETFs

BIS paper had suggested ETF sponsors may have sold illiquid assets to discourage redemptions amid Covid stress
BlackRock New York office
Jerry Goldberg

New research published by BlackRock attempts to dispel concerns over the origins of large discounts that hit its bond exchange-traded funds (ETFs) during the Covid-19 market stresses.

The BlackRock paper explores the process around “redemption baskets” and whether these were deliberately customised to discourage redemptions during the period of stress in March and April 2020.

ETFs are meant to track their benchmark index closely. To minimise “tracking error”, market-makers and broker-dealers create or redeem ETF shares, profiting from any gap between the ETF’s market price and the net asset value (NAV) of its underlying assets.

As a recent Bank for International Settlements paper notes, this mechanism seemed to break down during the Covid crisis, with discounts relative to the NAV as large as 5% in some bond ETFs. Something appeared to be stopping market-makers from exploiting a lucrative arbitrage opportunity.

Creation and redemption baskets for equity ETFs tend to have a very similar make-up to the underlying index, but this is harder to achieve for bond markets, where liquidity may be lower and bonds mature. Instead, ETF sponsors may propose a custom basket that contains different bonds to the index but with similar characteristics.

The BIS paper finds wide variation in baskets. These change over time, and creation baskets tend to differ from redemption baskets. Author Karamfil Todorov suggests that by varying the liquidity of the custom baskets, ETF sponsors could help to make redemptions less attractive during times of stress. But, he adds, this could undermine the ETF sponsor’s reputation in the longer term.

BlackRock’s paper pushes back against this narrative. It examines the custom baskets used during the most intense phase of the Covid-19 crisis in two of its major bond funds – one high yield and one investment grade.

“To our knowledge, this is the first such analysis of redemption baskets in the growing literature on ETFs,” the authors say.

They find that custom baskets had “nearly identical” risk characteristics and liquidity across different market conditions. They argue the large discounts observed during the Covid crisis were due to wider liquidity problems and uncertainty in the underlying bond market.

“Strategically choosing to regularly deliver out a concentrated basket of bonds that does not broadly represent the fund’s characteristics would generally not be in the best interest of the ETF and its shareholders and may lead to elevated tracking error,” the paper says. “Further, such actions could create reputational risk.”

The findings come as regulators consider how to respond to potential financial stability risks in the non-bank sector. The Financial Stability Board is due to publish policy proposals focused on money market funds in July.

The stability of bond ETFs is also a growing issue for monetary policy-makers. The Federal Reserve bought corporate bond ETFs as part of an asset purchase facility it created in response to the Covid-19 crisis.

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