Over the past couple of weeks, we’ve seen even more U.S. states fully reopening. Hopefully, for those of us living in the U.S., COVID-19 will stay in the rear-view mirror.
That makes it a good time to look back at what happened just over one year ago to markets.
The first reported death in China came on Jan. 11, 2020. Shortly afterward, we saw the first U.S. case. Wuhan was put on lockdown by Jan. 23. Within a month, equity markets were starting to get nervous, with a record volume day occurring on Feb. 28. This was well before quarantine lockdowns, which started a dramatic stock selloff. As we noted at the time, it was the fastest, though not the worst, bear market in history.
Of course, by the middle of March 2020, most of the U.S. was put on quarantine lockdowns, with only essential workers permitted to travel to work. At that time, data showed as many as 50% of employees out of work, and more than 50% of businesses shuttered. Markets of all asset classes sold off, breaking the traditional hedge that bonds and gold provide against an equity portfolio (Chart 1).
Chart 1: With businesses shut down for quarantine, almost all assets were being sold
Liquidity was an issue for fixed income markets also
What was less obvious was that similar strains were being put on the larger and less transparent fixed income market.
Early in the crisis, there were reports of “no liquidity” in the fixed income market. But not much public data is available on that market. Starting on March 12, 2020, the same day the WHO declared the novel Coronavirus a pandemic, we saw the Fed stepping in to support the bond markets. The E.U. vowed to do “whatever is necessary” by March 16. On March 23, the Fed announced it would be buying Bond ETFs in order to support the broad fixed income market.
Over time, it became obvious that investors had liquidated positions across a range of asset classes in a massive “dash for cash.” Fund flows showed that investors liquidated over $250 billion from bond funds in March 2020.
Chart 2: Bond fund flows show liquidations from mutual funds far larger than selling of ETFs
Even corporates were raising equity and debt to get themselves through the shutdowns. That one-sided flow made it hard for sellers to find buyers of their fixed income positions.
Bond ETF trading spiked as underlying bond liquidity evaporated
Some market participants feared ETFs in an environment like this. Their belief was that ETFs made it “too easy” to sell assets, and that would likely exacerbate any mass liquidation in the market. Corporate bond ETFs were considered especially exposed, given the illiquid underlying bonds even in normal markets.
However, the opposite happened.
Data actually shows redemptions from Bond Mutual Funds had a much larger impact (Chart 2).
In the face of gaps in underlying bond quotes we detail below, bond ETFs remained continuously quoted even as bond ETF trading spiked. As Chart 3 shows, bond ETF trading increased almost fivefold as depth in underlying bond markets fell.
In fact, order book depth of 10-year on-the-run securities in the interdealer market fell 90%, from around $250 million per day before COVID to a low of around $25 million per day in mid-March 2020. Despite the added difficulty hedging a bond ETF trade (or creation), fixed income ETFs traded a record $47 billion on Feb. 28, only to break that record on March 9, trading $53 billion.
Chart 3: Bond market liquidity deteriorated as bond ETF trading increased
Data from the bond market showed that trading in treasuries increased around $300 billion per day. However, most of this liquidity is in “on-the-run" or new issue bonds, making it harder than it looks to build a creation basket for an ETF.
Liquidity in the corporate bond market remained much smaller (green in Chart 4), totaling just $7 billion each day.
Chart 4: Reported bond market trading increased just 50% in March 2020
Spreads widened; bond markets dislocated
In the aftermath of the Covid selloff, studies have slowly come to light showing more details about what really happened in bond markets.
In an ICI postmortem, they highlighted that Covid disruptions in the fixed income market were first seen in the U.S. Treasury market. Data below also shows that spreads on off-the-run Treasuries, or older Treasury bonds, widened much more than new issue bonds in response to the liquidity crunch.
Chart 5a: The typical relationship between spreads on liquid and illiquid Treasury bonds gapped wider
Similarly, the normal relationship between overnight and short-term commercial borrowing completely broke down, with overnight costs falling while short-term funding costs increased.
Chart 5b: The typical relationship between spreads on short-term and overnight commercial paper broke down
Source: ICI calculations based on Bloomberg data
A report from the New York Fed (Chart 6) showed that spreads widened to levels last seen in the Credit Crisis, volatility breached those levels, and trading costs increased significantly.
Chart 6: Bond price volatility leaps higher, especially for the 30-year bond
In separate studies, the New York Fed also highlighted the collapse of bid prices for bonds in leveraged loan portfolios as well as a breakdown in normal relations between spot and forward mortgage-backed securities (MBS) markets during the pandemic.
Chart 7: Leveraged Loan bids plunged as Covid unfolded (S&P/LSTA US Leveraged Loan 100 Index)
Fed to the rescue
Other studies have looked at the impact of the Fed’s rapid and large response. The New York Fed highlighted the positive impact of the Fed responses during March 2020 helped to pull spreads and valuations back in line.
Chart 8: Spreads and yields started to return to normal after the Feds support plans were implemented
Part of the Fed’s response included buying bond ETFs.
Bonds vs. bond ETFs
We’ve written before that ETFs thrived in a Covid world. Investors used ETFs as tools to build positions quickly and cheaply in response to macro news, especially during Covid, they used ETFs to position thematic exposures.
As the activity we see above shows, bond ETFs were no exception.
It is true that as the selloff accelerated, bond ETFs traded at a discount to their underlying indexes (Chart 9). The big question, now that we know how underlying assets performed, is: Whether it was the ETFs or the underlying indexes that were mispriced?
Chart 9: ETFs traded at large discounts to NAV, as many experts on bond indexes expected.
All the bond market studies seem to confirm slow or stale reference quotes in underlying bonds existed, especially in the majority of bonds in an index, that are not new issues or on the run. For those, research seems to confirm that liquidity and quotes evaporated. Just as the market was selling off, many of those bond indexes’ prices were becoming days old, holding the index prices up.
In fact, a study by the Bank for International Settlements (BIS) discussed how ETF NAVs become “stale” during periods of market stress, the implication being the continuous trading of ETFs and their liquidity make ETFs a better tool for absorbing information flows more quickly than NAVs do.
Rather than the divergence between ETF prices and NAV indicating a problem with ETFs and panic selling, we instead see the opposite. ETFs were a superior price discovery tool, while bond market prices were an old and less accurate reflection of current supply and demand.
It’s important to note that the through the Secondary Market Corporate Credit Facility (SMCCF) in order to support the broader market, prices of ETFs also recovered faster than the underlying indexes, and ultimately the prices of both recovered. However, the first actual Bond ETF purchase didn’t happen until mid-May.
What’s next? Bond ETF taper time
The next ETF test for the bond market will be when the Fed unwinds those ETF purchases. However, based on a recent study by Jane Street, the Fed purchases represent a fraction of recent inflows into those bond funds, which would seem to indicate that the ETF market itself will be able to digest subsequent selling. In fact, the Fed already started on June 7, and so far, markets have hardly noticed.
Chart 10: The next ETF test for the bond market: unwinding the Fed’s portfolio
Lessons from Covid
The COVID-19 pandemic has taught us all many lessons. We are all armchair experts in mRNA and virology, and we’ve (mostly) worked out how to work from home.
But there are lessons for markets, too.
One is to see the benefits that a continuously quoting and public marketplace that brings all buyers together to find the best bids in times of stress.
Another is to show that ETFs can help, rather than hurt, liquidity in these times of stress.
From the multiple studies that have come out of the crisis, we can see the importance of diverse, healthy and liquid markets with readily available hedges and cheap trading. We also see that’s much more likely where transparency is higher.
Robert Jankiewicz, Research Specialist for Economic Research at Nasdaq, contributed to this article.