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buyers and sellers of ETFs could exchange shares without having to trade the underlying secur- ities. Second, in the “primary market,” where ETF shares are created or redeemed, an ETF portfolio manager could choose between the many bonds in the ETF’s underlying index and port- folio, providing flexibility while still tracking the index.
“Because of the size and scale of ETFs,” Johnston says, “they’re able to find the areas of liquidity that they need.” In contrast, he adds, an investor owning an indi- vidual bond must find a buyer for “that exact bond, because it’s the only one [they] hold.”
Some investors, however, became spooked when fixed- income ETFs began to trade at significant discounts to their net asset value (NAV) during the height of the market crash. According to the Bank of Eng- land’s May 2020 Interim Finan- cial Report, “in mid-March, some of the largest ETFs in both the investment-grade and high- yield corporate bond segments recorded NAV discounts in excess of 5%, having been no larger than 0.1% in January.”
Market-makers establish an ETF’s NAV based on the trading of the underlying fixed-income securities, which typically is executed by bond dealers on an over-the-counter basis, not on
a centralized exchange. Gener- ally, bonds tend to be less liquid than stocks. As bond markets seized up in March, ETF prices began drifting below the NAVs, indicating that the market con- sidered those NAVs to be stale.
“You have to benchmark the
ETF price against what you think is the correct fair value, and that’s very difficult [when the underlying bonds aren’t trading],” says Robin Marshall, director of fixed-income research with FTSE International Ltd. (a.k.a. FTSE Russell) in London.
In fact, bond ETF trading provided the market with a much needed price-discovery mechanism, according to an April 2020 report published by the Switzerland-based Bank for International Settlements. “The NAV discounts that opened up in the corporate bond ETF market in mid- March 2020 highlighted that, especially in challenging times, ETF prices react to new information more quickly than NAVs do,” the report stated.
The bid/ask spreads on bond ETFs — the difference between the highest price at which a buyer is willing to pay and the lowest prices a seller is willing to sell — also widened considerably in March, leading to higher trading costs.
Says Hussein Rashid, vice president and ETF strategist at Invesco Can- ada Ltd. in Toronto: “You’re going to have to pay a little bit more to get out of that position during periods of significant uncertainty or volatility.”
Of course, the intervention by the U.S. Federal Reserve Board and other global central banks at the height of the crash did much to buoy the overall market and reduce the discounts to NAV. Not only did
the Fed step in to buy invest- ment-grade and high-yield corporate bonds, but it also purchased fixed-income ETFs for the first time. That action allowed the Fed to get “access to literally hundreds of U.S. invest-
ment-grade corporate bonds in a single trade,” Cooke says.
Clients are likely to view the Fed’s decision to buy bond ETFs as a vote of confidence, Johnston says: “In some respects, [the Fed] is the
ultimate buyer.”
Industry experts foresee both retail and institutional investors con-
tinuing to flock to fixed income ETFs. At the end of June, global fixed-in- come ETF assets under management reached a high of US$1.3 trillion, representing an increase of 30% over the previous 12 months, according to a July 2020 report from New York-based asset manager BlackRock Inc.
In a low-yield environment, investors are increasingly drawn to the low cost of fixed-income ETFs, Johnston says, and “indications are that those lower rates are here to stay, and every basis point matters in that case.”
Rashid agrees, but says financial advisors and their clients may scru- tinize the fixed-income ETFs they hold more thoroughly in the aftermath of the March crash and shy away from products that are less transparent.
“If you don’t know what you’re going to be holding inside an ETF, you can have exposure to something that maybe you’re not comfortable with or you didn’t sign up for,” Rashid says. “I think it’s not so much a flight to quality. It’s more: ‘I need to understand what’s inside this ETF, and is it going to be right for my particular client?’”
    The Fed’s intervention helped buoy the market and reduce the discounts to NAV
 8 Investment Executive’s ETF Guide 2020

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