The Road to Premiums is Paved with Good Intentions: Perspective on the Fed and ETFs

by David Mann of Franklin Templeton Investments, 3/27/20

The US Federal Reserve recently announced a number of measures to support the economy and markets amid the coronavirus crisis. One involves the purchase of fixed income exchange-traded funds (ETFs). David Mann, Head of Capital Markets, Global ETFs, shares his thoughts on the subject, and what he thinks is the best way to support the corporate bond market through these purchases.

In my last post, I noted that the Federal Reserve (Fed) might start buying some corporate bond ETFs as part of its Secondary Market Corporate Credit Facility (“Facility”).

To summarize the key ETF references in the release notice:

  • Eligible ETFs. Any US-listed ETF whose main objective is to provide exposure to the US investment-grade corporate bond market.
  • ETF Limits: The Facility will not purchase more than 20% of the fund’s assets as of March 22, 2020.
  • ETF Pricing: The Facility will avoid purchasing shares of eligible ETFs at premiums to net asset value (NAV).1

The Million-Dollar Question: Which ETFs Are They Going to Buy?

Let’s start with eligibility. As of March 22, we estimate there are around 60 ETFs focused solely on US investment-grade corporate bonds, with combined assets under management (AUM) of approximately $140 billion. These funds range from the very big ($30 billion+) to the very small ($3 million) and include both active and passive strategies.

Now, if by the time you read this it is announced that the plan is simply to buy 20% of all of those funds, thus leading to a nice ETF investment of $28 billion across the board, feel free to click that “X” in the upper right corner of your browser right now.

Assuming that is not the case, then some decisions need to be made on which ETFs should be included in the Facility. The early speculation is that the investments would only go into the largest investment-grade bond ETFs.

I think that would be a huge mistake, and completely counter-productive to the spirit of the Facility.

The purpose of the Fed’s Facility is to support the corporate debt market by purchasing corporate bonds and/or corporate bond portfolios via ETFs. Purchasing only the largest ETFs with the highest average daily volume will not achieve this goal. One of the most frequently touted soundbites from the ETF community (especially the community that has high volume funds) regarding fixed income ETFs is some version of: “the fixed income ETF serves as a price discovery vehicle, allowing buyers to transact with sellers on exchange without having to impact the underlying bond market.”

Heck, I even said something very similar in my last post.

The ETFs with the most volume tout those high numbers as a liquidity benefit, specifically focusing on how little they impact the underlying market. That is the opposite of what is needed here! We want that ETF volume to impact the underlying bond market!

A very crude metric to measure the impact an ETF has on the underlying bond market is looking at the ratio of exchange volume to create/redeem volume. A ratio of 1:1 would mean every dollar traded on exchange is flowing into the underlying bond market. A ratio of 4:1 would indicate only $0.25 of every dollar traded on exchange leads to the buying or selling of bonds.

To give a sense of that ratio for the top five largest ETFs, they have a weighted average ratio of 5:1. Only $0.20 of every dollar of exchange volume in those funds results in trades in the underlying investment-grade corporate bonds market.

The Facility should want low ratios as those ETF trades would lead to actual buying of the underlying bonds. Our recommendation would be to focus on low-ratio ETFs (for example, under 3:1 over the past 12 months) as we want that primary market activity. Purchasing high-ratio ETFs may not even lead to any buying of the underlying bonds, depending on what is happening in the market that day.

The 3:1 universe has a combined AUM of around $40 billion, which would lead to an $8 billion ETF investment that should flow directly to the underlying bond market. Mission accomplished!