In Equity Trenches, Blowout Spreads, Discounts and Lots of Fear

(Bloomberg) --

Trading in the U.S. equity vortex was as harrowing as you’d expect it to be Thursday, with virus panic stirring the worst sell-off in a decade. Prices whipped around with almost unheard-of ferocity. It took longer to get fills, big gaps opened up between buyers and sellers, and pricing in exchange-traded funds obsessed everyone.

Equity liquidity was thinning prior to Thursday. Researchers at Goldman Sachs counted a median 10 contracts worth about $1.5 million resting recently at bid and ask prices in the most popular S&P 500 futures, compared with 120 contracts worth $18 million in 2019. Books thinned out as volatility was spiraling, a situation that normally causes market makers to pull back.

At the same time, according to about a dozen pros reached by Bloomberg, any confident assertion that the market “broke” Thursday was probably a stretch.

Were things frustrating and panicked? Absolutely. Expensive, too, going by the width of spreads, particularly in options. In ETFs, concern grew when funds traded far away from the value of their component parts, especially when the parts were bonds. But others argued the stock-borne products bailed out traders who couldn’t get reliable prices elsewhere.

Illiquidity and volatility are inextricably linked, they said. You don’t get one without the other. When losses approach 10% in the S&P 500 it’s crazy to think it could be any other way.

“It’s manageable,” said Joseph Saluzzi, Themis Trading LLC partner and co-head of equity trading. “The system is operational, we haven’t had any hiccups. Liquidity out there is difficult, the spreads are wider -- that’s expected when volatility is this high. If you’re a seller, it’s very difficult, if you’re a buyer, that’s a little easier.”

Most of the liquidity scrutiny focused on ETFs, which in some cases fell well below the value of their assets. The VanEck Vectors High Yield Municipal Index ETF traded at an 8.6% discount, the largest among more than 2,000 U.S.-listed products and the biggest for the fund ever. The Invesco Global Short Term High Yield Bond ETF isn’t far behind with a 6.1% gap. A larger peer, the $31 billion iShares iBoxx $ Investment Grade Corporate Bond ETF, slid 3.3% below the reported price of its parts, the widest since 2008.

Here’s what the traders said they experienced Thursday.

James Pillow, a managing director at Moors and Cabot

Funds comprising high-yield municipal bonds that normally trade right at the net asset value drifted a long way away -- as much as 8%. -- an extreme gap by any standard, Pillow said.

“That’s the best way to describe it, just extreme,” he said. “Those are the widest spreads in well over five years. That’s an opportunity for those providing liquidity. The biggest muni CEF [closed-end funds], offered by the same provider, have some of their large, high-quality muni trading at 10-12% discounts to their underlying holdings. That is about a 50-70% discount to how most of those CEFs trade. This fear is creating a liquidity vacuum not seen in well over a decade.”

Will Wall, Riverfront Investment Group

Wall, a manager of trading and operations, builds most of his portfolios using ETFs, which have been whipsawed.

“We’re seeing spreads in ETFs widen out and I think the market makers are just overwhelmed in general with the sharp volatility. They’ve taken a lot of risk and are now passing that risk on to the investors.”

Jacob Rappaport, INTL FCstone

The head of equities in New York said away from ETFs the market-wide circuit breakers that went off five minutes into trading helped, but left U.S. investors trying to catch up to the rest of the world when things came back on. Systems are being stressed, with data dumps occasionally slowing feeds.

“We are getting a ton of calls from clients asking to give an accurate read on where the markets are trading. There’s latency. We’ve had customers call us and say connections are going down for various providers. There’s so much volume to push through. Everyone’s overloaded. We do have some buy orders, fortunately. In 2008 there were no buy orders to be found.”

Mike Beth, WallachBeth Capital

The vice president for equity and derivative trading in New Jersey-based WallachBeth Capital received 50% more phone calls on Thursday morning than usual. Some institutional clients used the rout to buy on the cheap after “strategically waiting for prices to come to them.” Larger sell orders are being filled at a discount as bid-ask spreads are widening, but overall conditions aren’t bad.

“It has not been one way, with traders and institutions taking the opportunity to buy at lower levels. Given the two-way flow, we have seen liquidity available, but when we have a relief rally liquidity does feel a bit lighter. Bid-ask spreads are always wider in the morning but this is much wider than normal. Definitely part of the new high volatility regime we are in.”

Frank Cappelleri, Instinet LLC:

The senior equity trader & market technician at Instinet in New York said every sign of strength in the market is met with selling.

“We can write and talk all we want about the unprecedented movement. But whether they are 1%, 3% or 5% moves, there’s simply been no upside follow through on the rally attempts, and that has kept the momentum firmly in the bears’ grasp. Another face ripper is most likely imminent, but with already having seen some of the biggest percentage gains in history over the last three weeks. Who is going to trust it?”

Scott Bauer, Prosper Trading Academy

The chief executive officer at the Chicago firm says liquidity was present, it’s possible to trade, it’s just that you’re going to pay for it, sometimes dearly. He pointed to a highly liquid stock such as Costco, whose options usually have a bid-ask spread that’s 10 or 15 cents wide. On Thursday, some were as wide as a dollar or more.

“There’s definitely liquidity out there, but when there’s more risk, there has to be more potential reward. The issue is the bid-ask width,” he said by phone. “It makes it much more difficult to trade. Pepsi is another perfect example -- unbelievable amount of open interest, liquidity, but the bid-asks are upwards of $1 wide.”

--With assistance from Lu Wang and Claire Ballentine.

To contact the reporters on this story: Elena Popina in New York at epopina@bloomberg.net;Vildana Hajric in New York at vhajric1@bloomberg.net

To contact the editors responsible for this story: Courtney Dentch at cdentch1@bloomberg.net, Jeremy Herron

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