Fixed-Income ETFs: What Happens During Bond Panics? (Premiums, Discounts & More)

ETFs typically trade at something close to 'fair value.'

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ETFs typically trade at something close to "fair value." That is, if you calculated the intraday value of all the securities an ETF holds, that would roughly align with the price of the ETF.

The process that keeps ETFs trading at "fair value" is the creation/redemption mechanism. If, at any time, the price of the ETF deviates from the price of the underlying portfolio, institutional investors can swoop in and arbitrage the difference.

It happens like this: If an ETF is trading above fair value, investors can buy up the individual holdings in the ETF and trade them in to the ETF issuer for new shares in the ETF priced at par. They can sell those shares into the inflated market, earning a risk-free profit and helping to drive the ETF's share price back in line with the underlying securities. If an ETF is trading "cheap," the process reverses.

There are various ways and places that this near-perfect relationship gets upset. The most high-profile—and important—is in fixed income. Fixed-income ETFs—particularly in times of stress—can trade to massive premiums or discounts to their net asset values (NAVs).

The question this article aims to answer is: Is this a problem with the ETF or a problem with the underlying bond market?

The Bond Market Is Different

Compared with stocks—like those in the S&P 500, which trade throughout the day on the NYSE and Nasdaq—bonds are relatively illiquid, and their true price is harder to know with certainty. For example, shares of Apple are fungible, so the last price at which a share was traded is a very good representation of the current value of every Apple share. The bond market is different.

First, bonds trade much less frequently than stocks—so the last traded price might not be current at all. Second, they don't trade on an exchange: Most bond trades are individual "over the counter" agreements between two parties. Third, bonds come in much greater variety than stocks; for example, Exxon has many bond issues, each with different maturities and coupons, and each requiring its own price. Fourth, ETF issuers generally rely on bond pricing services for "fair" value estimations of their holdings; these estimations are based on the current selling price the fund might receive were it to start selling its bonds immediately. That fire-sale price will always be less than what you could pay to buy the bond, so there's a "natural" depression in the reported NAV of all bond ETFs.

For all of these reasons, it's not uncommon that a highly liquid bond ETF can serve as price discovery for the true fair value of the basket of bonds it holds. In other words, the market price of the bond ETF can be a better approximation of the aggregate value of the ETF's underlying basket bonds than its own NAV. Therefore, large premiums and discounts do not necessarily signal any mispricing in the ETF.

The idea of price discovery—where the ETF's market price is actually "ahead" of its NAV and is the best representation of fair value—shows up in other corners of the ETF world. For example, imagine a Japanese equity fund. The underlying stocks trade in Tokyo during their day, but the ETF trades throughout the U.S. trading day. Negative Japan news occurring in the morning here in the U.S. after the Tokyo market closes will depress the ETF share price, but its NAV will be unchanged, producing a large discount on that day.

To be clear, large premiums and discounts can't be safely ignored in all cases, and ETF share prices aren't always in the right when they don't match NAV. Sometimes large premiums and discounts signal that the ETF itself trades poorly and is therefore a lousy price-discovery vehicle. Still, the relative illiquidity of the bond market means that bond ETF premiums and discounts can't be relied upon blindly.

One general rule: A bond ETF is likely to be an efficient price-discovery vehicle—and therefore indicate that any large premiums and discounts aren't a sign of trouble—if the ETF's shares trade with great frequency and high volume.

Next: Commodity ETFs: Why You Can't Buy Spot Oil :A Guide To Contango And Backwardation

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Fixed-Income ETFs: The Basics
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