This week’s sharp sell-off in U.S. municipal bonds was a strain of the same November flu that’s been affecting Europe’s peripheral debt markets. Between huge financing deficits, heavy debt burdens, issuers stuck in a currency union and therefore unable to print their way out of the problem and rising yields in other markets, it’s not surprising munis tumbled just as Irish and Portuguese bonds have been doing.
But the sharpness of the sell-off in municipal bonds has also thrown the functioning of related ETFs into question. ETF prices dropped faster than the same funds’ net asset values in an echo of how corporate bond ETFs performed during the worst part of the October 2008 panic. (We wrote about that episode back then in a story called “As Arbitrage Falters, Bond ETFs Teeter.”)
The chart below shows how the price (in green), of the iShares S&P National Municipal Bond Fund (NYSEArca: MUB) has compared to the same fund’s indicative intraday net asset value (the black line) in the past 14 trading days.
The first obvious divergence between the ETF’s price and NAV occurred on Nov. 10, last Wednesday, but the biggest gap opened up on Nov. 15 and Nov. 16, Monday and Tuesday of this week. By this morning (Friday Nov. 19), things were apparently back to normal, and the ETF’s price and NAV were back in line.
Broadly speaking, ETFs are supposed to trade in the secondary market in line with their net asset values. But if the liquidity of the underlying investments becomes impaired, the arbitrage mechanism that ensures convergence between price and NAV struggles to work. It’s also worth pointing out that whether intraday NAVs are based on the bid or ask prices of the underlying bonds can have a significant effect on the size of any discount.
In turn, you can look at this week’s events in two ways.
The more optimistic slant—and this is the gloss on the situation that you’ll typically hear from issuers—is that ETFs are acting as a price discovery mechanism. When it becomes difficult to execute transactions in a particular sector of the market—say, municipal bonds—an ETF’s price tells you what the real price for those bonds are in the aggregate.
There’s a good example in the chart of how the iShares ETF acted in precisely this way. On Nov. 11, the U.S. bond market was closed for Veterans Day, but the equity market stayed open for trading. ETFs trade as equities, and that includes those funds that are based on other asset classes, such as bonds. The fact that the bond market was closed explains why there’s no intraday net asset value for that day in the MUB chart, and nor has iShares published an official end-of-day NAV. The open status of the ETF market, however, meant that, as MUB’s price fell on Nov. 11, investors got valuable information about what to expect the next day when the bond market reopened.
A more worrying take on all this, however, is that liquidity in many parts of the market obviously remains fragile. This is not an ETF-specific problem, of course. ETFs don’t cause liquidity problems by themselves: they merely reflect what’s going on in the underlying asset class. But the very fact that ETFs promise intraday tradeability means that when liquidity is no longer there—in corporate bond ETFs in 2008, during the “flash crash,” or this week in municipal bonds—there’s a presentation problem, at the very least.
And the more assets flow via ETFs into potentially illiquid areas—emerging markets come to mind—the greater the potential for a mishap that tarnishes the whole sector.
You can’t stop issuers from launching funds based on ever-more exotic underlying asset class exposures, and nor should anyone try to. But, from a liquidity point of view, not all markets are as suitable as others to be packaged in an ETF format
Bond ETFs, in particular, have experienced pricing difficulties of the type we saw this week with a little too much frequency for anyone’s comfort. After all, the great credit bubble created an awful lot of IOUs that no one really wants to own. This week, municipal bond ETFs threw up another reminder that you can’t take the safety or liquidity of this “safe” asset class for granted.