CONTRIBUTORS
David Mann
Head of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton
While there still isn’t complete clarity surrounding the Federal Reserve’s purchases of exchange-traded funds (ETFs), it did recently release a bit more information. David Mann, our Head of Capital Markets, Global ETFs, attempts to solve the mystery of which ETFs the Fed might be buying—and when.
I have talked a lot recently in these pages about the Federal Reserve’s (Fed’s) range of measures to support the financial markets during these times of coronavirus-driven turmoil, including the buying of fixed income ETFs. What I had intended to be my final article on the topic applauded the inclusion of ETFs in the Fed’s Secondary Market Corporate Credit Facility (SMCCF) program, but I also thought it was a shame that, without specific guidance from the Fed, the market simply assumed that only the largest ETFs would be included.
There was recently a bit more news on the subject. On May 4, the Fed released a document titled “FAQs: Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.” There was no further clarity on which ETFs would be included beyond the initial guidance, but the Fed did state that ETF purchases would begin in early May. Additionally, there was one FAQ that did grab my attention:
At What Price Will the SMCCF Purchase ETFs?
The SMCCF will generally not purchase shares of an ETF that are trading at a premium above the lower of the following limits relative to the prior end-of-day official net asset value (NAV):1 (a) 1%, or (b) the 1-standard deviation level of the ETF’s premiums to end-of-day NAV observed over the prior 52 weeks, on a rolling basis.
Some quick thoughts, given the market has expected purchases of the largest fixed income ETFs:
- Most likely, (b) will determine the premium threshold.
Looking at the 12 months ending in April, the top five largest ETFs that invest in investment-grade corporate bonds had an average 1-standard deviation premium of 69 basis points (bps).2 To get a sense of how chaotic the months of March and April were, removing those two months reduces the average 1-standard deviation premium to 9 bps!
- Since both (a) and (b) are elevated, the Fed can essentially buy those largest ETFs whenever they want.
Put to the side the flexibility provided by the word “generally” at the beginning of that sentence. Looking at April alone, that huge spike to the 1-standard deviation premium means the Fed could have bought those top five ETFs approximately 61% of the time.
Taken together, the market can still only speculate on which investment-grade (and high-yield) ETFs will be purchased but, because the 1-standard deviation premium threshold is so high, the bar as to when to buy ETFs is set incredibly low. I highlighted above that the Fed could have bought those top five ETFs 61% of the time in April.
The percentage of days that the Franklin Templeton fixed income investment-grade ETF could have been bought by the Fed was even higher at over 80% for April.
The market expects the Fed to purchase the largest funds—and inflows since March 23 offer proof of that line of thinking. We now have some clarity that the Fed has a tremendous amount of price flexibility as to when they should buy any of the eligible funds.
The next few weeks should show if the market got it right in its assessment of which ETFs the Fed chose to buy.
ENDNOTES
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Net Asset Value (NAV) represents an ETF’s per-share-value. The NAV per share is determined by dividing the total NAV of the fund by the number of shares outstanding.
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A basis point is a unit of measurement. One basis point is equal to 0.01%.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Distributions to shareholders may decline when prevailing interest rates fall or when the fund experiences defaults on debt securities it holds. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The fund’s investments in foreign securities involve certain risks including currency fluctuations, and economic and political uncertainties. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Investing in derivative securities and the use of foreign currency techniques involve special risks as such may not achieve the anticipated benefits and/or may result in losses to the fund. These and other risks are discussed in the fund’s prospectus.
Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.