A Wild Week For Fixed-Income

As the financial markets react to the covid-19 crisis, many investors are focused on the wild price action in equity markets. However, much more interesting and consequential things are happening in fixed-income markets. We saw crazy price action in Treasuries, MBS, and fixed-income ETFs, which I’ve outlined below.

Treasuries

This past Monday, Treasuries opened at levels never seen before. Below is a YTD chart of the 10-year Treasury yield, which touched .33% on Monday morning before rebounding the rest of the week. Moves of this magnitude are unprecedented and highlight a few issues:

  • There was a massive flight to safety. The steep drop in rates may have been reinforced by convexity hedging (as mortgage holders may have been forced to buy more Treasuries as prices rose, thereby driving rates down even more).
  • There were many reports this week about Treasuries being as illiquid as they’ve ever been. This likely exacerbated price volatility.
  • Even if yields are expected to fall to (or below) 0%, I personally do not see a lot reasons for individual investors to own medium- or long-term Treasuries at these levels. The yields are unattractive and the interest rate risk is high (even if the probability of a sharp rise in yields may be low). Why not just hold cash?

Mortgage-Backed Securities

Agency mortgage-backed securities (MBS) are generally viewed as safe assets due to their government guarantee. However, the aforementioned illiquidity hit MBS a lot harder than Treasuries. The top panel of the below chart shows that MBS yields often trade at a premium to Treasury yields, but that spread blew out to crisis levels this past week (see the bottom panel). To my knowledge, there is still no question about the credit quality of Agency MBS, so the spike in spreads is a liquidity issue rather than a credit issue (and which many expect that the Federal Reserve will resolve).

Fixed-Income ETFs

Fixed-income ETFs had a very weird week as well, as many fixed-income ETFs traded well below their Net Asset Values (NAV). While this happens from time to time in less liquid sectors (such as high yield), we saw this phenomenon for the first time in many investment grade funds. The $50B Vanguard Total Bond Market ETF traded at a deep discount to its NAV on Thursday. Interestingly, since Vanguards ETFs are simply a share class of their existing mutual funds, an investor could have redeemed their mutual fund investment at NAV and bought the same portfolio back (through the ETF) at a 6%+ discount! If you do not understand fixed-income fund NAVs or ETF redemption mechanics, Dave Nadig wrote a good explainer on it or check out Rick Ferri’s analogy.

Although unprecedented, it is quite conceivable how a discount could appear for a fund holding at least some credit. However, we saw similar action in ETFs that only hold Treasuries. Even the $20B iShares 20+ Year Treasury Bond ETF traded at a ~5% discount to the underlying value of its holdings. Treasuries are the most liquid asset in the world, so it is indicative of just how much volatility and illiquidity exists in the Treasury market.

Looking Ahead

The above examples indicate an extreme level of illiquidity in the financial markets. We are witnessing things that we have not seen since 2008 or ever before. Who knew that Treasuries could swing so wildly? Who thought that Agency MBS would trade so wide of Treasuries? And who could imagine a Treasury ETF trading at a deep discount to its NAV. NAVs are certainly moving around more than usual (and probably more than expected for most), but this illiquidity also brings unprecedented opportunity as some safe* assets are clearly mispriced.

*Safe meaning backed by the US federal government. There is a lot of credit (non-government) fixed-income trading at very distressed levels right now, but the above post is not focused on credit assets.

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