Volatility in the market created a price divergence between exchange traded funds and their benchmark indices, causing a disadvantage for investors selling those securities over the past few weeks.
That is what the Municipal Securities Rulemaking Board found in an
“The price divergence was potentially caused by a liquidity crunch that would have made executing the arbitraging activities to swiftly narrow the pricing gap challenging,” Simon Wu, MSRB's chief economist wrote in the report. “Authorized participants would likely have been discouraged from, or less effective in, arbitraging if they had difficulties in selling the bonds they received for ETF share redemption.”
Those participants redeem or issue ETF shares and buy and sell assets that underline the ETFs to keep the price of the ETF fairly close to the net asset value. The NAV is the average weighted value of all of the bonds in the index.
A volatile market makes it difficult for those participants to engage in transactions to keep the price of the ETF and the NAV similar so that the price accurately reflects the value of the underlying securities.
The MSRB explored the price movement of three of the most frequently traded ETFs — the iShares National Muni Bond ETF (MUB), the Vanguard tax-exempt bond index fund (VTEB) and the VanEck Vector High Yield municipal bond index (HYD).
Close tracking of a portfolio’s net asset value by a corresponding ETF’s price is important since the deviation from the NAV can result in investors purchasing or selling a financial product whose value is different from what investors reasonably believe it to be, Wu wrote.
Before March 2020, MUB and VTEB tracked closely with the S&P National AMT-Free municipal bond index — an index designed to measure the performance of investment-grade muni bonds. The two ETFs tracked closely with the S&P index with a daily percentage deviation between 0.01% and 0.4%.
However, starting on March 10, MUB and VTEB consistently diverged from the S&P index and were underpriced for about 10 trading days before converging again in late March, the MSRB found. The daily percentage deviation reached as high as 5.9% for MUB on March 18 and 9.4% for VTEB on March 19.
Price divergence was even worse for HYD. Its price divergence peaked with a discount of 28.3% on March 18.
The high-yield municipal market is still facing issues, said Michael Decker, senior vice president of policy and research at Bond Dealers of America.
“We’ve seen some recovery in the investment-grade, but the high- yield world still seems to be with illiquid and it’s still not functioning as normal,” Decker said.
Patrick Luby, senior municipal strategist at CreditSights, said liquidity wasn’t the only factor causing the price divergence, but also more trading volume. Volume of trading in the ETFs may be a better indicator, he said.
“The ETFs have so much more trading volume than any individual bond,” Luby said.
Thousands of bonds in an index may not have traded in a while, Luby added, making the NAV less informative.
Using MUB as an example, from March 16-27, the top nine CUSIPs in the MUB had a total of 164 trades with a $69.3 million par amount. Over the same time frame, the entire MUB traded more than 160,000 trades with a volume of $4.5 billion.
“The volume of trading in the ETFs, because of that, is a better indicator of where the market really is,” Luby said.
In the next few weeks, Luby expects the Federal Reserve will take more action to support the muni bond market.
In the corporate bond market, the Fed is buying ETFs following its announcement of its Secondary Market Corporate Credit Facility last month.
“If they were to buy secondary market municipals and they were to buy municipal ETFs, that would have a really strong influence on the market,” Luby said. “You’d have a really big buyer coming in and supporting the market.”
