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BIS Bulletin No 6: The Recent Distress in Corporate Bond Markets: Cues from ETFs

Core Content

This BIS Bulletin examines the impact of the 2020 pandemic on corporate bond markets, with a focus on the role of exchange-traded funds (ETFs) in reflecting market stress and liquidity issues. The analysis highlights how ETFs, which are designed to track underlying indices, provide more timely and reactive price signals compared to traditional bond benchmarks. The study draws on data from mid-2020 to assess the functioning of corporate bond markets and the effects of policy interventions.

Main Points

• Corporate Bond ETFs in Distress: In March 2020, corporate bond ETFs traded at steep discounts to their net asset values (NAVs), reflecting heightened market stress and liquidity concerns.
• Market Stress Phases: The pandemic-induced market disruptions unfolded in three phases:
  1. Risk-off phase (mid-January): primarily affected equities, commodities, and FX markets.
  2. Flight to safety phase (late February): impacted government bond markets and corporate credit spreads.
  3. Dash for cash phase (early March): led to severe dislocations in corporate credit markets, including significant spreads and ETF discounts.
• ETFs as Price Discovery Tools: ETF prices incorporate new information more quickly than NAVs, especially during market stress. This makes ETF prices more suitable for monitoring and risk management models.
• Illiquidity and Dealer Behavior: Corporate bond markets were illiquid, and dealers reduced their risk-taking, which exacerbated ETF discounts. This was due to increased uncertainty and the need to preserve balance sheet capacity.
• Policy Interventions: Central bank actions, such as the Federal Reserve's Treasury and mortgage-backed securities purchase programme, helped alleviate dealer liquidity constraints and reduce ETF discounts.

Key Insights

• ETF Price vs NAV Dynamics: ETF prices react more quickly to market changes than NAVs, which are calculated daily. This leads to NAV deviations during volatile periods.
• Spillover Effects of Policy: Policy interventions in one market segment can have temporary but significant effects on other segments through investor portfolio rebalancing.
• Investor Behavior: The shift from ETFs to money market funds (MMFs) during the crisis suggests that investors were rebalancing their portfolios in response to liquidity concerns and policy support.
• Credit Risk and Liquidity: The gap between bond spreads and CDS spreads widened during the crisis, indicating that cash bond markets were more strained than derivatives markets.

Summary of Graphs and Data

• Graph 1: Corporate credit spreads widened, especially in high-yield (HY) segments, with the largest declines observed in the US and Europe.
• Graph 2: NAV discounts were significant in both IG and HY ETFs, with larger discounts in the US for IG ETFs and wider dispersion in HY ETFs.
• Graph 3: Dealer risk-taking declined in early March, with a notable drop in net purchases of IG and HY bonds. Policy actions, such as the MMLF and Fed's purchase programme, helped restore liquidity and reduce ETF discounts.
• Graph 4: ETF prices incorporate new information more rapidly than NAVs, especially during periods of high volatility. NAV returns are better predicted by their own lagged values than by ETF price returns.

Conclusion

The BIS Bulletin underscores the importance of ETF prices as indicators of market stress and liquidity conditions in corporate bond markets. It also highlights the spillover effects of policy interventions and the critical role of dealer behavior in market functioning. The findings suggest that ETFs can serve as more dynamic tools for monitoring and managing risk in financial markets, especially during times of crisis.