Pricing and Liquidity of Fixed Income ETFs in the Covid-19 Crisis of 2020

EII Global Research

As of July, 2020

ICRMH0920U-1319728-1/13

How Did Fixed Income ETFs Behave During the Covid-19 Crisis?

• Fixed income ETFs generally performed as expected and provided an alternate source of liquidity for challenged bond markets.

• Market participants turned to fixed income ETFs for price discovery.

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VIX

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HYG secondary volume VIX

Pricing – Fixed income ETFs reflected real-time value

Liquidity – Fixed income ETFs were efficient to trade

The Arbitrage Mechanism –performed as expected.

iShares iBoxx $ High Yield Corporate Bond ETF (HYG) secondary volume vs. Cboe Volatility Index

Source: BlackRock, Bloomberg (data as of March 24, 2020)

We demonstrate this by evaluating the following dynamics:

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ICRMH0920U-1319728-2/13

Price Discovery:

During the height of the volatility in March 2020, bond ETFs posted large price discounts from Net Asset Value (NAV).

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Pri

ce

($)

GE 4.125% 2035 ABIBB 4.9% 2046CVS 4.3% 2028 GS 6.75% 2037VZ 4.329% 2028 LQD

A Window Into Real Time PricingPrices of LQD vs. Top Holdings

January-February

March-April

TLT 0.13% 0.86%

LQD 0.13% 1.39%

HYG 0.21% 1.06%

Average Absolute Stated Premium / Discount to NAV

Are Large Premiums and Discounts to NAV

Problematic?

Source: FINRA TRACE, Bloomberg. As of 3/23/2020.

Holdings are subject to change. Holdings shown should not be deemed as a

recommendation to buy or sell securities. For complete holdings, see www.ishares.com

Source: BlackRock, based on data from Bloomberg as of 4/30/2020.

NO.There is information

value.

ICRMH0920U-1319728-3/13

Price Discovery:Market Price vs. NAV?

What Causes Discounts on Bond ETFs vs. NAV?

Fund NAV is calculated once per day using actual trades, dealer “runs”, and estimation methods.

The ETF price reflects an actionable trade on exchange.

These dynamics are exacerbated during periods of volatility.

Majority of bonds do not trade on a given day – NAV largely based on estimation.Trading activity in LQD universe, March 2020

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HY (Price Domain) IG (Spread Domain)

Deviation of Dealer Quotes to Actual Trade Price

Source: FINRA TRACE, BlackRock from 3/2/2020 – 3/20/2020. Includes only end

investor buys and sells – not dealer-to-dealer trades.

Source: FINRA TRACE, Dealer quotations.

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Price Discovery: Intraday Intrinsic Value?

As of 6/26/2020. Source: BlackRock, Bloomberg and Refinitiv.

• Bottoms-up, bond-by-bond valuation, calculated throughout the day.

• 12-factor intraday bond valuation model developed by BlackRock in 2015.

What Is Intraday Intrinsic Value?

• On March 24th: HYG traded at 2.4% closing premium to NAV, but only a 0.4% average intraday premium to Intrinsic Value.

Intrinsic Value Offers an Intraday Estimate of ETF Premium /

Discount

(900)

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(300)

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iShares HYG ETF

flow at T (right axis) iShares IV ETF Price NAV at T-1

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iShares HYG ETF

P/D to NAV at T-1 P/D to iShares IV ETF b/a spread (right axis)

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Price Discovery: The presence of lag effects in Net Asset Values

Daily NAV-Based Returns Exhibit Positive

Correlation to the Previous Day’s NAV

Return.

Daily ETF Total Returns Have Tended To Be

Uncorrelated To Past Returns.

Source: BlackRock, based on daily NAV returns from Bloomberg

Autocorrelation Function for LQD 1/2/20-4/30/20

Autocorrelation Function for HYG 1/2/20-4/30/20

ICRMH0920U-1319728-6/13

Price Discovery: Large Premiums/Discounts Do Not Persist

Source: BlackRock, Bloomberg. 3/31/20

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ET

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NA

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FLOT LQD MUB HYG TLT Net Asset Value

Bond ETF Prices and NAV Converge As Markets Normalize, March 2020

ETF Price Reflects Real-

Time, Actionable Value for Portfolio.

Convergence occurs once

volatility / lag effects dissipate

Price Innovation in NAV tends to

lag.

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Liquidity: Bond ETF volumes tend to accelerate during Volatility

While liquidity became challenged in the

underlying bond markets, bond ETFs traded at record

volumes on exchange.

Source: BlackRock, based on data from Bloomberg as of 4/30/2020.

Average Daily Exchange Volumes ($bn)

Average Primary to Secondary Volume %

Average daily volume during Q1 2020 was more

than 2x that of 2019.

Primary to secondary ratio rose modestly in stress

period

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$0.5

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FLOT LQD HYG TLT MUB$

bil

lio

ns

2019 1Q-2020

January-February

March-April

TLT 9.83% 10.28%LQD 12.99% 14.66%HYG 7.99% 9.58%

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Liquidity: Bid-ask spreads – “liquidity mismatch”?

Source: BlackRock, Bloomberg. 3/31/20

Average bid/ask spread (price bps), March 2020

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BroadMarket

U.S.treasuries

Investmentgrade

corporates

High yieldcorporates

Emergingmarket

debt

ETF bid/offer Underlying bid/offer

Bid/ask spreads for fixed income ETFs are much lower than that of

individual bonds.

No. Bond ETFs should trade at tighter spreads (portfolio effects,

transparency/efficiency of exchange).

Bond ETFs represent a diversified portfolio of bonds: less

idiosyncratic risk than individual bonds.

Is this a concern - “Liquidity mismatch”?

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Is the Bond ETF Arbitrage Mechanism Efficient?

When the ETF share price trades at a true (actionable) premium or discount to the value of the securities held by the ETF, there is an ECONOMIC INCENTIVE for Authorized Participants (APs) to create or redeem shares to capture value (and thereby close the differential).

Bond ETF is trading at a true discount to est. portfolio value(ETF $85, bond portfolio $90)

AP buys ETF shares on

exchange for $85

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AP redeems ETF shares,

receives underlying

bonds, closes out trades.

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AP sells underlying

bonds in the market for

$90.

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AP profits $5.

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Simple Example of bond ETF arbitrage:

APs are generally not incentivized to engage in creation/redemption unless the arbitrage is (i) actionable and (ii) profitable (or at least neutral)For illustrative purposes only. Although market makers will generally take advantage of differences between the NAV and the trading price of

iShares ETF shares through arbitrage opportunities, there is no guarantee that they will do so.

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Can there be “Wrong Way” Arbitrage?

TLT LQD HYG

Estimate p-Value Estimate p-Value Estimate p-Value

Intercept -0.02 0.03 0.00 0.06 -0.01 0.06

Premium.IV 46.08 0.01 1.76 0.04 0.84 0.56

Crisis 0.03 0.01 0.01 0.00 0.02 0.01

Premium.IV*Crisis -43.69 0.02 -1.39 0.10 -0.33 0.82

Adj. R-Squared 0.455 0.336 0.158

Recent academic research purports the existence of “wrong way” arbitrage in bond ETFs driven by dealer balance sheet dynamics:

• Motivation to manage bond inventory and balance sheet costs outweighs the loss on the “wrong way” arbitrage.

• Two primary issues with the theory:

– Conflation of broker-dealer / AP and market-maker roles

– Use of closing premiums/discounts to NAV which are end of day valuations subject to lag effects

We regress bond ETF creation/redemption flows on the average intraday premium/discount to intrinsic value and add an interaction term for the crisis period. In no case are the coefficients negative. Accordingly, we find no evidence of wrong way arbitrage even in times of market stress.

Regression Estimates of Daily Primary Flows Scaled by AUM

Source: BlackRock, based on data from Bloomberg as of 4/30/2020. Estimates that are significant at the 5% confidence level are in bold.

ICRMH0920U-1319728-11/13

Conclusions

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Bond ETFs serve as vehicles for efficient price discovery

• Amid increased trading during the Covid-19 crisis, fixed income ETFs were indicators of real-time, actionable prices.

• Bond ETF prices showed large deviations from NAV. However, we believe these deviations were a function of price discovery coupled with NAV latency effects in a challenged liquidity environment.

• Bond ETF prices represented actionable values on exchange based on elevated volumes.

• We find that Intraday Intrinsic Value provides real-time information value relative to end-of-day estimates.

Bond ETFs were more efficient to trade than the underlying bonds.

• While fixed income ETF trading costs are generally cheaper than those of underlying bonds, this difference was magnified during the Covid-19 crisis.

• Bond ETFs traded in record volume while the underlying market experienced liquidity challenges.

We find no evidence supporting claims of “wrong way” arbitrage.

• We find no empirical evidence for the claim that Authorized Participants are motivated to engage in money losing bond ETF primary transactions due to balance sheet dynamics.

ICRMH0920U-1319728-12/13

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ICRMH0920U-1319728-13/13