Franklin Templeton comments on Fed’s purchase of investment grade bond ETFs

US Federal Reserve

Late March saw The Federal Reserve establish the Secondary Market Corporate Credit Facility (SMCCF) to support credit to employers by providing liquidity to the market for outstanding corporate bonds.

That liquidity was to come through the purchase in the secondary market of corporate bonds issued by investment grade US companies or certain US companies that were investment grade as of 22 March, 2020, but also, for the first time, included US-listed ETFs whose investment objective is to provide broad exposure to the market for US corporate bonds. 

ETF limits for this programme were that the Facility would not purchase more than 20 per cent of the fund’s assets as of 22 March, 2020 and that the Facility would avoid purchasing shares of eligible ETFs at premiums to net asset value (NAV).

The result of the announcement was that within the week, the top five ETFs that provide exposure to investment grade bonds brought in about USD6 billion, implying that the market thought this was a good idea too.

There is still no evidence, at the time of writing, that the Fed has actually bought the ETFs.

Following this story in a series of blog posts, David Mann, head of Capital Markets, Global ETFs at Franklin Templeton wrote: “Furthermore, those funds had an average premium to NAV of almost 1.5 per cent on the back of almost USD40 billion of notional volume. Those actions reflect a market that expects a big buyer to enter sometime soon.”

Mann says: “When I saw the announcement that the Fed was going to buy investment grade bonds and ETFs that hold investment grade bonds, a lot of things were bouncing around in my head.”

Franklin Templeton has a USD690 million investment grade fund. Mann says: “I was curious as to whether the spirit was to buy ETFs under the assumption those purchases would flow into the underlying bonds or do we now need to think more about how ETFs are trading in the market, because not every dollar in the market flows into underlying bonds.”

The market reaction to the Fed’s announcement meant that the largest ETFs saw the biggest influx of dollars. “Whether or not the Fed meant this to happen, the default was that there was lots of buying of the largest and highest volume ETFs in the asset class,” Mann says.

High yield ETFs have now also been included in the programme and have brought in a further USD35 billion.

“It’s unfortunate that we spend so much time talking and educating on trading so investors don’t just look at the volume and size of each fund in order to buy the biggest – these are misconceptions that are easily explained if you talk to someone in the ETF capital markets or a liquidity provider,” Mann says.

“One of the talking points of having ETFs with higher volumes is that it allows all of this trading on exchange without having to impact the underlying markets, which is one of the nice things about ETFs.”

However, Mann argues that the Fed should be buying ETFs of all sizes, otherwise they are de facto supporting the ETF’s stock price.

“Did the announcement cause some settling of the underlying bond market?” Mann asks. “Yes, the Fed’s blanket announcement seemed to create some buying pressure in both investment grade and high yield bond ETFs although now we are explaining ETF premiums instead of ETF discounts.”

However, Mann does see that it’s good news for ETFs that the Fed acknowledged ETFs as a viable vehicle of choice for investors.

“It’s the first time the Fed has done this and responded to some illiquidity in the investment grade bond market by announcing they would buy both investment grade bonds and ETFs in that market.”

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Beverly Chandler
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