Rare market stresses are emerging in the world of bond ETFs as volatility grips Wall Street ahead of the crucial Federal Reserve meeting.

Cash prices in two of the largest high-yield exchange-traded funds closed at steep discounts to the value of their underlying assets on Monday, as bonds posted historic losses in the hawkish aftermath of last week’s shock inflation print.

The $13.4 billion iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) ended Monday 1.2% below its net asset value -- the largest dislocation since March 2020. The $6.8 billion SPDR Bloomberg High Yield Bond ETF (JNK) closed at a 1.8% discount, in the biggest divergence since 2016. 

Such price inconsistencies are normally repaired by specialized traders known as authorized participants, who pocket a virtually risk-free profit in the process. But heightened volatility can complicate that process, particularly with fixed-income ETFs, which trade much more frequently than the debt securities they hold. 

“Liquidity in riskier areas is beginning to evaporate, which means fewer trades and more individual bonds with stale pricing,” said Nate Geraci, president of the advisory firm The ETF Store. “With less trading in the underlying, junk bond ETFs are serving as price discovery vehicles and the current discounts are reflecting early signs of credit stress.”

HYG and JNK both fell 3.4% on Monday in the biggest drop since April 2020. The ETFs fluctuated on Tuesday as the S&P 500 wavered between gains and losses after closing in bear market territory the day before.

Typically, as an ETF’s price drop, APs will buy shares of the fund to redeem with its issuer in exchange for the underlying assets. In the case of HYG, those traders would then sell the bonds, capturing the arbitrage opportunity. 

Discounts on fixed-income ETFs reached even steeper levels in March 2020, when trading in bond markets effectively froze as the pandemic spurred unprecedented upheaval. It wasn’t until the Fed announced that it would backstop the corporate credit market that order was restored.

As with the junk debt ETFs, discounts have also opened up in the $4.8 billion Invesco Senior Loan ETF (BKLN) and the $9 billion SPDR Blackstone Senior Loan ETF (SRLN). However no such dislocations have emerged for government-bond funds like the $19 billion iShares 20+ Year Treasury Bond ETF (TLT). 

“Twenty-year plus Treasuries trade all day, so if TLT traded at a discount someone could arb it,” said David Schawel, Family Management Corp. chief investment officer. “If HYG trades at a discount are you certain it can be arbed? Not really, because you don’t know if you can execute at current marks.”

This article was provided by Bloomberg News.