What caused junk-muni ETF to go into freefall?

No one seems to know quite what to make of the stunning price drop in the largest high-yield municipal-bond exchange-traded fund.
The VanEck Vectors High Yield Municipal Index (ticker HYD), with $3.6 billion in assets, was the picture of tranquility for much of the past three years. From the start of 2017 through February, its share price traded in a range of less than $7, starting at $59.26 and climbing to as high as $66.14 on February 26.
Then something snapped suddenly. It fell 1% on March 6. Then 5% on March 9. Then 3.4% and 2.3% on March 10 and 11 before plunging a whopping 15.6% on March 12 during the worst stock rout since Black Monday in 1987. Within the span of about two weeks, it had dropped from an all-time high to an all-time low. It was such a violent sell-off that it triggered the US Securities and Exchange Commission’s “alternative uptick rule,” which restricts short selling from further driving down the price of a stock that has dropped more than 10% from the previous day’s close. The moves started days before the rest of the market cracked.
Because the ETF reacted so fast, its price fell much further than what the bonds it owns would indicate. By March 12, HYD tumbled to a record 19% below its net-asset value, which Bloomberg News’s Katherine Greifeld calculated as the single-biggest discount in the entire $4.4 trillion ETF market.
So, what’s going on here? I have a hunch that it centres on a combination of risks unique to the
coronavirus pandemic, unique to high-yield municipal bonds and unique to the ETF structure.
First, about the ETF structure. The unprecedented volatility in everything from risky corporate bonds to US Treasuries has caused market-makers to step back in an effort to avoid getting caught in a bad position. In ETFs, these are known as authorised participants, as Greifeld explains:
“Rampant turbulence across bonds markets is souring appetite for the arbitrage opportunity that normally keeps ETF prices in lockstep with a fund’s value. Normally, middlemen known as authorised participants will buy shares of a falling ETF in order to exchange for the underlying bonds with the fund’s issuer. That market maker will then sell those securities to pocket a virtually risk-free profit. The ETF’s price usually snaps back to the fund’s net-asset value as the supply of ETF shares is reduced.
But fear over the coronavirus’s economic fallout has unleashed historical volatility in fixed income, making it harder to unload the underlying bonds. As a result, the ETFs are trading at persistent discounts as thin liquidity sidelines market makers.”
Without question, that dynamic explains part of HYD’s huge discount. But it’s also crucial to understand the idiosyncratic nature of the high-yield muni market.
With some notable exceptions, speculative-grade munis just don’t trade very often in the sort of size that would interest institutional buyers. That’s because no two issuers are quite the same.

—Bloomberg