Fed to begin buying corporate debt ETFs

Fixed-income exchange-traded funds, once a signal of an impending liquidity crisis in corporate bonds, are now a peculiar part of the cure.

First announced by the Federal Reserve in late March, the Secondary Market Corporate Credit Facility managed by BlackRock for the Federal Reserve Bank of New York to purchase up to $250 billion in corporate bonds and ETFs through at least the end of September.

In advance of individual bond purchases, the facility expects to begin purchasing ETFs as of Tuesday with holdings reported in aggregate weekly and by position monthly. According to the investment management agreement posted on the New York Fed website, ETFs can be bought in the secondary market or through wholesale creations of new ETF shares.

The inclusion of ETFs in the facility is a testament to how far fixed-income ETFs have come in the past decade, now totaling $860 billion in assets under management in the U.S., with more than half arriving in just the past five years. But the revelation that ETFs would actually jump-start the SMCCF puts a finer point on their utility.

"Buying ETFs is an indirect way to offer liquidity to a wider swath of the market," said Kelly Ye, head of research at IndexIQ, a unit of New York Life Investment Management LLC. ETFs not only provide a level of price discovery for the component bonds, but also meet the needs of the investment managers and institutional investors that use ETFs for cash equitization, transition management, and facilitating basket trades to support portfolios of relatively less-liquid individual bonds, she said.

While the core function of the SMCCF is secondary market liquidity — in both bonds and ETFs — the purchase of broad-based investment-grade and high-yield corporate bond ETFs is also an apolitical way to support securities prices across the spectrum.

For example, BlackRock's iShares iBoxx $ Investment Grade Corporate Bond ETF holds more than 2,100 bonds. The fund has an effective duration of 9.2 years with an expense ratio of 0.15%. And the SPDR Bloomberg Barclays High Yield Bond ETF from State Street Global Advisors holds more than 1,000 high-yield bonds. The fund has an effective duration of four years and an expense ratio of 0.4%.

Yet, there are likely only a handful of corporate bond ETFs that could meet the Fed's liquidity needs. For example, of 139 corporate bond ETFs, only 17 trade more than 1 million shares per day, according to XTF Inc. The investment management agreement did not reveal any specific details regarding eligible ETF metrics, other to say that premiums and discounts to NAV and creation/redemption volume would be included in the consideration.

The program terms revealed in late March stated that BlackRock would not earn asset management fees on any ETFs in the SMCCF portfolio and, specifically, would rebate the underlying expense ratio on any BlackRock ETFs purchased. Moreover, the manager is expected to report and consult with the New York Fed when holdings of BlackRock-sponsored ETFs "exceeds or is expected to exceed" the market share of BlackRock-sponsored ETFs in the corporate bond ETF market (roughly 50% of assets under management).

In mid-March, many of the largest and most liquid bond ETFs moved to unprecedented discounts to net asset value as the reality of COVID-19 challenges mounted. Several investment-grade products swung to similarly extreme premiums following the March 23 announcement of the Fed facility, but significant discounts in high-yield ETFs persisted until the April 9 announcement of the facility's extension to high-yield products.

Though still volatile, premiums and discounts have collapsed from their highs and lows of two months ago. The SMCCF has stipulated that it will not buy any products trading at a 1% premium to end of day NAV or one standard deviation above its rolling 52-week premium (whichever is lower).

The Fed (via BlackRock) has to ensure that it doesn't overstep its bounds. Any increase in demand for ETF shares compels market makers to seek out the underlying bonds, receive newly created ETF shares in exchange for those bonds, and sell the ETF shares to capture the premium.

This is precisely what John Keller, head of ETF product management at bond trading platform MarketAxess Holdings Inc. in New York observed during the recent volatility. "When there are larger-than-usual discounts and premiums, we see more activity on our platform from the ETF community," Mr. Keller said. In fact, the bond market dislocation in March helped drive record usage of MarketAxess's Open Trading marketplace among both investment managers and securities dealers, which CEO Rick McVey said on the company's April 29 earnings conference call "demonstrates a trading behavior change that will lead to an even better global fixed-income market in the years ahead."

The Fed as a holder of ETFs also poses a new, but familiar, challenge for issuers.

"I've got to prepare for the potential of a decent-sized, quasi-tactical investor who could significantly impact the supply/demand equation for fund shares," said Fran Rodilosso, fixed-income portfolio manager at VanEck, issuer of the $1.7 billion VanEck Vectors Fallen Angel High Yield Bond ETF.

The terms of the SMCCF provide for buying "fallen angels" that were previously rated investment grade as of March 22, but it also gives the facility the ability to buy high-yield bond ETFs that VanEck's Mr. Rodilosso said "would allow for mild support for riskier credit without picking winners and losers."