Underneath the Hood of Fixed Income ETFs: Primary and Secondary Market Dynamics

Transcription

1 Underneath the Hood of Fixed Income ETFs: Primary and Secondary Market Dynamics BY DAVID B. MAZZA, VICE PRESIDENT, HEAD OF RESEARCH, SPDR ETFs AND SSgA FUNDS STATE STREET GLOBAL ADVISORS WITH THE SPDR ETF CAPITAL MARKETS GROUP What are fixed income ETFs? Are they really that different than equity ETFs? Fixed income and equity ETFs are regulated and structured in the same manner. They have similar investment objectives, such as to match the total returns and characteristics of indexes through full replication of sampling strategies. What is often different, and may not be fully understood, is that many fixed income indices cannot be fully replicated. Full replication can be both cost prohibitive and difficult due to the over-the-counter (OTC) nature of bond trading. Issue fragmentation also presents challenges to full replication. For example, a large US multinational company has one common stock in the market but over 1,00 individual bond issues outstanding. Moreover, even if the indices can be fully replicated it may not be practical to do so because of the underlying illiquid and opaque nature of many areas of the bond market. Investors have been turning to fixed income ETFs as a cost effective and transparent vehicle to add exposure to this generally opaque bond market. Due to their unique creation/redemption process, ETFs may offer investors a more cost-efficient mechanism for managing bond exposures as every transaction doesn t require actual buys/sells of bonds. Rather, shares of the ETF trade on an exchange with frequent interactions between sponsors and the market making/ Authorized Participant (AP) community. While only APs can interact with sponsors to create or redeem fixed income ETF shares, the primary market processes can have an impact on investors experience accessing ETFs in the secondary market. Understanding more about how fixed income ETFs work can help investors create resilient portfolios in a rapidly evolving market. Some distinct features of fixed income ETFs discussed in this paper include: In-Kind and Cash Creation/Redemption Process OTC Market and Impact on FI ETF Trading Bid Side NAV Pricing ETF vs. Underlying Basket Value Basketing Process and Sampling CREATION/REDEMPTION To better understand how fixed income ETFs operate, it is helpful to examine how shares are created and redeemed and how this process differs when trading fixed income ETFs versus equity ETFs. A feature of all ETFs is the way by which fund shares are created and redeemed. This creation/redemption process takes place in the primary market between fund sponsors and APs. 1 APs create fund shares in large increments, known as creation units, by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size (typically 50,000 ETF shares) then delivering those securities to the fund sponsor in-kind. In return, the AP receives fund shares which are then introduced to the secondary market where they are traded between buyers and sellers through the exchange. The same is true in reverse for redemption orders. Since securities are transferred in-kind, there is no physical buying of securities by the ETF sponsor except for rebalancing. This in-kind transfer in the primary market is a non-taxable event for existing shareholders. FIGURE 1: THE CREATION REDEMPTION PROCESS Source: State Street Global Advisors. spdrs.com

2 As equities trade on stock exchanges, they share broadly similar characteristics to ETFs, such as current and historical bid/offers, closing auctions, and a trading history with average share price and dollar volumes. This transparency and accessibility of information makes the sourcing of an ETF s underlying equities for creations/redemptions highly efficient, enabling a greater number of trading participants to create and redeem equity ETFs. FIXED INCOME IN THE PRIMARY MARKET Fixed income markets operate somewhat differently. Most notably, fixed income securities trade over-the-counter (OTC), which means that there is no central exchange, pricing center or official opening/closing price. This creates a market that is more fragmented and less transparent. ETF trading desks price their own inventory of bonds by scrubbing through multiple dealer quotes or other pricing sources to generate a fair value for each fixed income ETF. In addition to bond bid/ask spreads being variable and sometimes volatile, trading costs can escalate in times of market distress. For more liquid segments of the fixed income market, such as Treasuries, the bonds tend to be tighter from a bid/ask spread perspective and the pricing tends to be more consistent across dealers. Less liquid markets, such as investment grade and high yield corporate bonds, tend to have wider spreads and a wider degree of pricing variation due to less publicly available information and the general risks that exist relative to US Treasury bonds. The less transparent nature of this market can make it more difficult and/or expensive to transact in. In light of this, many fund providers offer various methods by which to create or redeem ETF shares, something all investors should be aware of. Whether an ETF is fully replicated, such as a US TIPS ETF or sampled such as an intermediate corporate bond ETF, the primary method for creation/redemption for most SPDR fixed income ETFs is in-kind. There are some sectors or areas of the market that do not allow for in-kind delivery, thus, the primary method for creating shares is via cash plus fees, referred to as a variable cash fee. An example of this is senior secured loans, where standard settlement of the loans require an exchange of signature and can take longer than T + 7days. In this example, for an AP to create new ETF shares, they would deliver a cash amount that represents the number of shares being created at that day s NAV, plus the predetermined fee that covers the cost of the portfolio manager having to source FIGURE : CASH VS. IN-KIND CREATION & REDEMPTION PROCESS 1 BONDS ETF Provider ETF SHARES Source: State Street Global Advisors. Authorized Participant In Kind (eg: Treasuries) OR CASH 1 ETF SHARES 4 CASH Open Market ETF Provider BONDS Authorized Participant Cash (eg: Bank Loans) 3 those loans in the market. The SPDR Blackstone / GSO Senior Loan ETF (SRLN) currently charges APs a variable cash fee of 15 bps to create ETF shares and 5 bps to redeem ETF shares, which will factor into how market makers price the ETF on the secondary market for customers to buy or sell. In addition, it is worth noting that variable cash fees help to externalize costs, thus protecting the fund and existing shareholders from the impact of buying/selling underlying bonds directly in the market. These primary market fees, which are always available to the AP community, can fluctuate daily based on market conditions. As previously mentioned, the primary method for most funds is in-kind, with portfolio manager approval required for cash. Ultimately, portfolio managers accommodate cash requests to facilitate primary market liquidity in the event that there is no adverse impact to the fund. PRIMARY MARKET DYNAMIC: IN-KIND SAMPLING In addition to the cash and full basket options available to APs when creating/redeeming fixed income ETFs, portfolio managers can also utilize the primary market to more effectively manage a fund to its benchmark while maximizing a funds tradability. For certain fixed income ETFs, portfolio managers publish baskets that fluctuate on a daily basis and might have little overlap with the redemption basket. This process allows the portfolio manager to adjust characteristics such as duration, maturity and economic sectors according to the best interest of shareholders. Many fixed income ETFs are sampled or optimized to their respective index in order to reflect the uniqueness of the underlying market. Sampling-type techniques may be used in both equity and fixed income ETFs, although due to the illiquid and at times opaque nature of some areas of the bond market, sampling is even more prevalent in fixed income ETFs. For example, if over time through the sampling process the ETF has become overweight the utility sector, today s creation basket will most likely have more exposure to other sectors such as financials and industrials, and today s redemption basket would have a skew to utilities. At the same time, the portfolio manager is looking to balance liquidity needs by asking for bonds that are attainable by the market making community, and the same is true in reverse for redemptions. In other words, portfolio managers need to be cognizant that the underlying market may not facilitate the ability to transact in certain names that would improve the portfolio s ability to track its index. Hence, there exists a balance between hypothetically perfect liquidity and perfect tracking error. Notably, the basketing process, which differs across ETF providers, impacts the normal bid/ask spreads. SECONDARY MARKETS ETF PREMIUM/DISCOUNT TO NAV The relationship between an ETF s secondary market price and its net asset value (NAV) is referred to as a funds premium or discount. When ETF shares are trading at a higher price than NAV, a fund is said to be trading at a premium, and when ETF shares are trading at a lower price than NAV a fund is said to be trading at a discount. One of the key advantages to the creation/redemption process is the ability to keep premiums and discounts between market prices and net assets values

3 in check. When trading equity ETFs, if the ETF price becomes dislocated from the value of its underlying basket, there is a potential arbitrage opportunity that exists. If the ETF is trading at a premium to its fair value, a market maker can take advantage of the potential arbitrage opportunity by selling the ETF at the premium and simultaneously buying the underlying portfolio of stocks. This sale of one instrument and purchase of the other helps to compress the differing values, bringing the premium or discount back to a tighter level where ETF shares and underlying basket prices (NAV) converge. At the end of the day, if the market maker is short ETF shares from selling and long the underlying basket, they can collapse that position by delivering the basket to the ETF sponsor to create new shares and settle their short positions. The availability of information, the accessibility to underlying shares and a correlated hedge, all factor into how efficient an ETF arbitrage opportunity can be. When there is more information available, it typically becomes less expensive to trade and easier to hedge positions, making the arbitrage band (premium/discount) tighter. As a result, on average, a smaller premium or discount should exist. When some or all of the underlying holdings are not open for trading and price discovery is taking place, as may be the case when dealing with international markets, there are a greater number of unknowns. Therefore, the arbitrage band can widen leading to more pronounced premiums or discounts. TRADING FIXED INCOME ETFS IN THE SECONDARY MARKET Similar to certain international equity ETFs, when the underlying securities are not open for trading, fixed income ETFs fall into the price discovery category. Here, there is no central pricing source or trading venue for the bonds, and in many cases some bonds have not traded in days or even weeks. To calculate NAV for fixed income ETFs, the fund administrator will use a pricing vendor to quote multiple resources for fair value (mutual funds rely on the same method to price NAV). The price used to calculate NAV is the evaluated bid for the underlying bonds. Whether the creation order is coming via in-kind or cash the underlying securities are being sourced at their respective offer side. The AP is paying the offer side of the bonds, or delivering cash plus a fee that covers that bid to offer spread, but that NAV is being struck at the bid side. Thus, fixed income ETFs tend to trade at a premium to NAV, under normal conditions, since bid pricing is the cost basis for creating shares and selling into the market. This lack of transparency in the NAV calculation also affects the intraday NAV (inav). The inav was designed to show the indicative value of the underlying portfolio intraday by taking the last printed price for each underlying security every 15 seconds. This serves as a fairly accurate tool for US equities that are open for trading and will show movements based on the last trade. However, inav becomes a less useful tool in fixed income because as previously discussed some of the underlying bonds may not be trading frequently, and there is no exchange or last trade database to gather the information. Figure 3 denotes this visually, by depicting the market price and inav of the SPDR Barclays High Yield Bond ETF (JNK) over a seven-day period in November 01. Leveraging an Institutional ETF trading desk or the Capital Markets desk of a fund sponsor, investors may be able to better understand an indicative price level for a fixed income ETF. FIGURE 3: JNK MARKET PRICE AND INDICITIVE NET ASSET VALUE Source: Bloomberg, L.P., State Street Global Advisors, from 11/01/01 11/09/01. The information contained above is for illustrative purposes only. SECONDARY MARKET DYNAMIC: USING FIXED INCOME ETFS AS PRICE DISCOVERY VEHICLES Secondary market liquidity in bonds has changed materially since the outset of the global financial crisis; banks/dealers have both a diminished ability to hold bonds in trading inventories and less willingness to take-on proprietary trading risk associated with market making. Therefore, it is important for investors to note that illiquid fixed income securities may not reflect the most recent information about the security s fundamentals because the bonds have not traded in a considerable time period and rely on pricing models to compensate for staleness. In a rapidly changing market, fixed income ETF prices may actually better reflect fair value than an ETF s underlying components, which may incorporate stagnant pricing from the last time they transacted in the market. An ETF s market price can act as a price discovery tool especially in times of heightened volatility as the ETF market price will represent what the trading community sees as fair value. The ETF can price information and sell faster than the bonds being marked in an OTC market, and thus the ETF might trade at a perceived premium/discount to the underlying fund value. However, these spikes in premiums or discounts tend to fluctuate as a function of secondary market ETF supply/demand and primary market creation/redemption. For example, the market price and NAV of the SPDR Barclays Short Term High Yield Bond ETF (SJNK) highlights this. SJNK normally trades at a premium to NAV as illustrated in the top panel of Figure 4, which details the period from April to August 013. During the selloff in late June, the fund traded at a discount as a result of heavy selling and large outflows. At the same time, the ETF was pricing in all available information intraday verses the basket of bonds, which was not trading as actively. As the redemption orders were processed and the oversupply of shares was removed, the ETF reverted to trading at a premium within its normal range. This highlights how the ETF structure can simultaneously allow for investors to express their opinion on an asset class while providing market participants with valuable information on real time market sentiment. 3

4 FIGURE 4: SJNK PREMIUM/DISCOUNT OVER TIME Source: Bloomberg, L.P., State Street Global Advisors, from 4/01/013 8/31/013. The information contained above is for illustrative purposes only. CONCLUSION Since launching in 004, fixed income ETFs now comprise 16% of the global ETF universe, with 879 offerings and $375.9 billion in assets under management. Because the ETF vehicle brings liquidity and on-screen pricing transparency to the fixed income market, the spread of fixed income ETFs can be much lower than the underlying basket of the bonds that they comprise. In addition, considering that ETFs can trade when underlying markets may be thinly traded or even frozen may even become more important as time passes. Thus, the drivers of growth in ETF fixed income products over the last ten years are likely to stay the same going forward as more and more investors come to recognize that fixed income ETFs offer access, and real time information to the bond market. 4

5 ABOUT SPDR ETFs SPDR ETFs are a comprehensive fund family of over 100 ETFs, spanning an array of international and domestic asset classes. Offered by State Street Global Advisors, SPDR ETFs provide investors with the flexibility to select investments that are precisely aligned to their investment strategy. Recognized as the industry pioneer, State Street Global Advisors created the first ETF in 1993 (SPDR S&P 500 Ticker SPY). Since then, we ve sustained our place as an industry innovator through the introduction of many ground-breaking products, including first-to-market launches with gold, international real estate, international fixed income and sector ETFs. For information about our ETF family, visit spdrs.com. STATE STREET GLOBAL ADVISORS State Street Financial Center One Lincoln Street Boston, MA spdrs.com 1 Authorized Participants are US registered self-clearing broker dealers that are approved to create or redeem ETF shares by interacting directly with the fund sponsor. FOR PUBLIC USE. IMPORTANT RISK INFORMATION The views expressed in this material are the views of Research and Capital Markets group through the period ended 3/31/014 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce return. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. There can be no assurance that a liquid market will be maintained for ETF shares. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. STANDARD & POOR S, S&P and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products. Further limitations and important information that could affect investors rights are described in the prospectus for the applicable product. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., a registered broker-dealer, is distributor for SPDR S&P 500, SPDR S&P MidCap 400 and SPDR Dow Jones Industrial Average, and all unit investment trusts. ALPS Distributors, Inc. is not affiliated with State Street Global Markets, LLC. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit spdrs.com. Read it carefully. 014 State Street Corporation. All Rights Reserved. ID1070-IBG Exp. Date: 6/30/015 IBG.PSMD