In baseball, the process of inadvertently revealing your upcoming pitch, giving the batter an outsized advantage, is called “tipping your pitch”.
Growing up near the shrine that is the Baseball Hall of Fame, I was acutely aware that the turning of the calendar to March means it’s baseball season. Watching, playing, coaching……I was surrounded. After years of exposure, either through practice or osmosis, baseball idioms find a home in your brain. Luckily for me, trading and idioms are a match made in bond heaven. Over the past year, the Credit ETF market served up a “meatball” in the form of structural trading inefficiencies between the equity and underlying assets. After experiencing the intra-day volatility of the past year, including the flows in recent weeks, Credit ETFs (the pitcher) are tipping their pitches, and the awareness of dealers/buy-side traders (the batters) is enhancing daily price volatility.
From the bush league to the majors, growth in Credit ETF AUM has increased the relevance of create/redeem trade flows.
The AUM of fixed income ETFs has grown substantially over the past 10yrs and is large enough to influence the functioning of markets with their daily flow activity. The Credit ETF market has morphed from a retail-focused product to one that has gained acceptance, and subsequently, usage by institutional investors. Credit ETFs were the “leadoff batter” when the Federal Reserve announced the Secondary Market Corporate Credit Facility (SMCCF) in the summer of last year; it took the FED another two months before they started bidding for individual bonds.
Credit ETF growth has been a home run in many instances.
Retail investors have a cost-efficient way to gain exposure to a historically hard to invest asset class. For institutional investors, the credit ETF market has opened new avenues for tactical asset allocation, risk mitigation, and hedging. In addition, credit ETF AUM and volume growth has fueled the rapidly expanding “portfolio trading” business. These developments have created a whole new ecosystem.
ETF shares trade with equity-like liquidity, but the underlying bonds do not, creating an intra-day game of pickle that can have a meaningful impact on implied valuations.
The Intra-day valuation of the ETF shares vs. the net asset value (NAV) of the underlying assets is widely tracked and communicated across several market participants using the “Intraday Indicative Value” function. Imbalanced buying/selling of credit ETF shares often creates an intraday divergence between the equity value and the implied value of the underlying corporate bonds. These divergences typically lead to the buying/selling of bonds to facilitate the create/redeem demand. Looking back over the past year, the frequency of these occurrences has increased due to market dislocations from the COVID-19 pandemic and the resulting policy implementations. The signaling of these intra-day moves is powerful, and a spike in either direction (discount/premium) will likely impact the trading strategy of both dealer & institutional trading desks
This leads me to the main point of this blog: the liquid component of the Credit ETF universe (the equity) is having an adverse impact on the liquidity of the underlying bonds. As a trader, three glaring factors are impacting the way we bid/offer into ETF flows:
- Create/Redeem baskets are posted daily – We know what ETFs are buying/selling.
- Intraday divergence in the share price vs. indicative value – We know when ETFs are buying/selling.
- ETF execution strategy is ultra-transparent – We understand how ETFs are buying/selling.
Do you want to be the buyer of the first wave of redeeming flows on a day when ETFs are trading at an outsized discount? I sure don’t, and neither do the dealers. We know what/when/how the ETFs are going to sell, so we’re going to “wait for our pitch” and try to pay less efficient prices (from a fundamental perspective). A similar mentality led to some choppy trading sessions last week, with the Bloomberg Barclays US Agg Corporate OAS widening 8bps between 03/04-03/09 (Index OAS ~9% wider over four trading days). Long story short, until corporate bond trading becomes more “equity-like”, the structure of Credit ETFs will lead to pricing inefficiencies at the underlying bond level, especially in periods of enhanced volatility. In the meantime, we’ll keep feasting on that ETF pitching!
