Issue link: https://resources.envestnet.com/i/1528445
3 FOR INVESTMENT PROFESSIONAL USE ONLY David Hawal Finding Equilibrium in the Bond Market? In the recent panic triggered by the COVID-19 pandemic, credit markets have witnessed a liquidity freeze as corporate and municipal bond managers face waves of redemptions. Even the most liquid government bonds have traded at record wide bid-ask spreads, while a number of fixed income ETFs are pricing at significant discounts to the NAV of their underlying holdings. ETFs had been touted as bastions of liquidity given their intra-day trading flexibility. However, just last week, Vanguard's Total Market Bond ETF (BND) closed at a 6% discount to NAV, highlighting a dislocation in the liquidity of the ETF's shares and its underlying securities. These effects have been even more amplified in less liquid segments of the market, like high yield. But how did we get here and what happens next? The answer may lie in the aftermath of the Financial Crisis and the enactment of the Volcker Rule, which aims to limit the financial risks banks can take by eliminating proprietary trading. While one can argue the steps the federal government took to bolster the solvency of the nation's banks has our financial system much better positioned entering the current crisis, we may also be seeing some unintended consequences. In the years following, PMC repeatedly asked the question of fixed income managers: Without bank prop desks to provide liquidity, who would be the buyer of last resort in the event of a mass exodus from credit? While we received a variety of speculation, the one response we never heard was the reality we've now ultimately seen play out – for the first time in history, the Federal Reserve would step in and intervene in the corporate bond market. Perhaps now, with the Fed as a backstop, fixed income markets that have seen spreads approaching Financial Crisis levels will return to normalcy. Eric Halverson Dry Powder Gone Sour? In recent periods, the term "dry powder" has been more prevalent in conversations with value-focused fixed income investment managers, and refers to the move to high-quality issuance, or even cash, when areas of the market appear overvalued. In theory, this "dry powder" can be put to use during market dislocations when valuations become more attractive. But when managers utilize comingled vehicles (such as mutual funds and ETFs) and redemptions start piling up during periods of market stress, does all of that dry powder go to waste as they are forced to meet withdrawals? This begs the question, should investors stick to separate accounts instead of comingled funds in liquidity-constrained asset classes like fixed income? Redemptions and forced sales still occur within separate accounts, but the decentralized nature of their management limits the negative impact to other investors, and more importantly retains the book yield of other accounts. Another factor to consider is the manner in which mutual fund managers choose to handle these redemptions. Are they selling their highest quality and most liquid holdings, leaving remaining shareholders with a portfolio of less liquid securities? This is something we are monitoring closely as we engage with our managers.