Fitch Ratings : The removal of Russian bonds from major indices has led to divestment and liquidity challenges for emerging market (EM) fixed income exchange traded funds (ETFs), says Fitch Ratings.
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The sharp decline in Russian bond liquidity, the lack of reliable pricing and the restricted access to the Russian market are making it difficult, if not impossible, for EM ETFs to sell their holdings, which they would otherwise seek to do in order to continue to match the risk and return characteristics of underlying index benchmarks.
Few Fitch-rated ETFs have exposure to Russia. These funds’ ratings are unlikely to be impacted from a Russia default or illiquidity scenario given the small exposure to potentially affected bonds and EM funds’ current sub-investment-grade ratings. Fund managers must also navigate second-order market volatility from the Russia-Ukraine conflict and the rapid increases in oil prices, interest rates and inflation, among other factors, which will create challenging conditions for emerging market ETFs.
JPMorgan and Bloomberg announced the removal of Russian bonds from their respective indices on the March 31 rebalancing date. Other index providers, such as MSCI and FTSE Russell, announced the removal of Russian bonds from their indices from close on March 9 and from open on March 7, respectively. Passively managed ETFs will likely try to exit their Russian positions based on the action the index they follow takes.
According to Bloomberg, Russian debt typically only accounts for 3%-4% of broad global fixed income EM ETFs, although some ETFs have smaller exposures due to recent market valuation decreases and active divestment by fund managers. For broad global EM ETFs where exposure is de minimis, bonds could be marked down and ETFs could elect to continue holding positions after index providers remove them from their indices.
Fund managers are more likely to try to sell positions if a willing buyer exists to more closely mirror underlying indices and minimize tracking errors between fund performance and the returns of the benchmark index it tracks. These errors can be exacerbated by high expense ratios or disparate holdings versus the underlying index. Tracking errors may be further increased by differences in fair-value determinations from managers and index providers, with some index providers marking the value of Russian bonds down to, or close to, zero. Market quotes for Russian securities are currently not readily available, which may leave funds to determine fair values using models. Fair-value prices are determined by the manager according to procedures adopted by the fund’s board of trustees.
The U.S. prohibited participation in the secondary market for all Russia-related sovereign debt issued on and after March 1, 2022, but funds can divest of bonds issued before this date if a buyer can be found. A 4.75% coupon Russian government dollar bond due 2026 was recently quoted at around eight cents, down from about 110 cents a month ago, according to Advantage Data. Ruble- and USD-denominated bonds have very limited or no liquidity according to fund managers. Bonds held by fixed-income ETFs that are affected by limited liquidity include those issued by the Russian sovereign, Gazprom, VEB Finance and Sberbank, according to Bloomberg.
On March 8, 2022, Fitch downgraded Russia to ‘C’ from ‘B’,, reflecting an imminent sovereign default. Russia previously announced it will only make payments on its foreign-owned debt using rubles, constituting a default on its dollar-denominated debt. However, Russia made a $117 million interest payment to foreign bondholders on March 16, 2022, averting default. There is still significant uncertainty regarding future payments, with some index providers such as Bloomberg having announced that for purposes of calculating index returns, all coupon payments will be deemed suspended for March.
“The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.”
Source: ETFWorld.co.uk
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