Bond Fund Pricing Volatile Amidst Coronavirus Pandemic
The coronavirus pandemic certainly did a number on Wall Street in the first quarter.
According to the Centers for Disease Control and Prevention (CDC), there have been 427,460 confirmed coronavirus cases in the U.S. so far. All 50 U.S. states have reported cases, as have Washington D.C., Guam, Puerto Rico, the Northern Mariana Islands, and the U.S. Virgin Islands. And there have been 14,696 deaths from the disease.
Thankfully, social distancing appears to be working. New coronavirus cases in hot beds like New York City are finally starting to stabilize, and some officials are predicting a peak in the very near future.
Still, the effects of the pandemic and stay-at-home orders will have a significant impact on the U.S. economy for the foreseeable future.
Despite breaking through to new all-time highs in mid-February, the broader indices quickly dropped more than 20% in March, falling into a bear market. Interestingly, as investors fled stocks and poured into “safe havens” like bonds, the bond market also started acting erratically.
As you may know, bond yields typically drop when investors are fleeing stocks and buying bonds. However, the opposite was true in the broad market selloff in early March. Bond yields were rising as stock prices were plummeting. So, the Federal Reserve stepped in to calm the bond and stock markets.
The Fed cut key interest rates to nearly zero. Then, they started a massive quantitative easing program, planning to buy $700 billion in Treasuries and mortgage-backed securities. After making more than half of these purchases in the first week of the program, the Fed decided to announce “unlimited” quantitative easing.
In addition, the Fed recently announced that it would also buy ETFs that track the corporate bond market. The move is aimed at shoring up the corporate bond market and ETFs, which have experienced record outflows during the coronavirus pandemic and market downturn.
For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) plummeted nearly 22% in nine trading days in early March. But, with the new quantitative easing program, the Fed can now purchase up to 20% of the assets of an ETF as long as it’s exposed to the investment-grade bond market. The announcement drove investors back into LQD, dropping more than $900 million into that ETF in one day.
That was the biggest influx of cash for the ETF since 2016. LQD is now up 20% from its mid-March lows.
These massive swings in corporate bond ETFs are more than a little concerning. The reality is that corporate bond ETFs still trade like stocks, not like their bond holdings. That means ETF premiums/discounts widen during volatile market conditions like what we saw during March. This gap makes ETFs more expensive to buy or sell.
LQD, for example, is now trading at a massive premium to its net asset value (NAV). In other words, LQD’s current price is not reflective of the value of its corporate bond holdings.
Clearly, the volatility in corporate bond ETFs is defeating the whole purpose of owning bonds in the first place. Bond investors want stability and, more important, income. Instead of gaining all of the principal at the time of sale, however, investors in corporate bond ETFs are selling at the NAV—and that could very well be much lower in the current market environment.
The opposite holds true for personalized bond portfolios.
Building a personal portfolio of bonds, rather than investing in a bucket of bonds through an ETF, can give income investors more safety and capital preservation. Yes, bond prices can fluctuate with the market’s daily swings, but their moves are more muted compared to stocks and ETFs.
It’s also worth noting that when you invest directly in bonds, you receive regular interest income. Also, at the time of maturity, you receive 100% of the principal.
That’s why we, at Nicollet Investment Management, prefer building personalized bond portfolios with individual bonds for our clients.