During market volatility, as we saw last week, the lion’s share of volume trading in corporate debt is due to exchange-traded fund selling. This is not good for investors because, in today’s world of index investing, there are few buyers who are willing to reach out and catch the proverbial knife. So, if you’re investing in index funds, you are right to be concerned when you see the net asset value of your fund decline. The pricing is usually determined by funds hitting bids with few buyers around to provide the liquidity that dealers are no longer willing to provide in any meaningful size. But for those investors who prefer their bond funds to be more carefully selected, a NAV decline may prove to be an opportunity.
Oftentimes, NAV decline stems from a combination of dealer fear lowering indicated prices and actual buyers who are looking to be opportunistic. The fewer the trades that take place in bonds of higher-quality credits (which is not the same as ratings), the more likely that sellers aren’t willing to make a sale, especially when buyers are bidding and trying to be available for motivated sellers that don’t appear. This is a sign of portfolio strength, even if the price has declined temporarily, but usually only for active managers who are selective in what they buy. Ultimately, those funds are in a position to win either way; either sellers capitulate and the funds get to buy attractive bonds at attractive prices in a down market, or the buyers have to pay up and the prices recover, often faster than the broader market represented by ETFs.
When ETFs experience redemptions and must sell bonds to raise cash, there are real offers. To sell their bonds, they issue what is known as a BWIC (“bid wanted, in competition”) to get as many potential buyers as possible to show them a bid, with the plan of selecting the best bid. If there aren’t many buyers, the bids will come in low. The good news for the ETF is that they will be able to sell the bonds; the bad news is that it may sell at a depressed price. Whether the issuers are on the stronger or weaker end of the credit spectrum becomes irrelevant to whether they are for sale, and opportunistic fundamental buyers will bid down for the best bonds for sale and show no bids for the rest. Most of the volume we’ve seen in the last week has been from ETFs forced to hit bad bids to raise cash. And poor credits remain for sale with no bids in sight.
However, the last week has been a tale of two markets. On the one hand, there are the bonds we just described, in which there are fewer buyers than sellers and where trades are taking place at depressed levels. Investors in these funds are realizing losses as their funds are forced to make sales.
There is another market, however, in which the observed volatility tells a very different story. For many bonds that are not held by ETFs (usually due to issue size or lack of inclusion in a relevant index), the dynamics are different. This subset of the market exists on the same spectrum of credit, with some on the stronger end and some on the weaker end. But in the recent market, showing bids in stronger credits that are not held by forced sellers has gotten buyers nowhere. Holders do not want to sell these bonds at lower prices, and there is little trading volume. Note that this is different from illiquidity – should a seller decide to offer bonds below where they had previously been trading, we would expect to see a feeding frenzy as buyers of good quality credits which don’t suffer from forced selling haven’t gone anywhere. They are trying to take advantage of a down market to try to get bonds lower, but sellers aren’t complying. They know what they own. In this case, counterintuitively, we’d argue that the lower trading volumes are a sign of higher liquidity.
In general, the allocator who wants a price decline to be an opportunity to buy rather than sell is looking for the fund manager who is vigilant, nimble and positioned to capitalize on motivated sellers (ETF or otherwise). Asset allocators should be looking for those characteristics of a portfolio that increases the chances that price declines are reflective of levels where buyers are eager to buy rather than where sellers are eager to sell. Such portfolios include shorter duration bonds, where the prices are naturally constrained by yields. For short duration bonds, small price declines can mean big yield differences, making it more likely that the bid side of the market is very real, even if it takes a little while for the prices to rebound.
A strategy that is designed to invest in bonds whose prices are naturally constrained by credit quality (not just rating) and/or duration tends to benefit from volatile markets even as there may be some movement in the underlying bonds and the fund NAVs. These are the managers that, in the words of the great Warren Buffett (Trades, Portfolio), are “fearful when others are greedy and greedy when others are fearful.” In markets like the one we are in today, the investors that sleep at night are the ones that were best positioned to be greedy these last several days. If you can find them, they might just present a good opportunity to distinguish the kind of NAV decline worth owning.
Disclosure: Zeo Capital Advisors
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