HYG is also the poster child for another type of NAV accounting issue having to do with how bond prices update. NAV accountants use inputs from bond pricing services, while HYG’s price is based on real-time market activity.
Most bonds are illiquid, often trading maybe once a week or once a month. This is especially true in the high-yield market. Yet accountants need daily valuations to calculate NAVs. They turn to bond pricing services, which employ models to estimate a bond’s daily price based on recent trades in similar bonds. These models are only as timely as their inputs, so if their sentinel bonds don’t trade, the models won’t update. This becomes an issue when there is a dislocation in bond markets, as many bonds don’t trade in the minutes, hours or days following an interest rate or credit shock. Bond pricing models may not catch up to new market conditions for a few days following a shock.
ETFs like HYG trade on equity exchanges and have live bids and offers during equity market hours. High volumes, along with tight spreads and good depth-of-book, mean HYG’s buyers and sellers generate real-time information about HYG’s prices. In effect, funds like HYG often act as price-discovery vehicles. While HYG’s price is often the best estimate of its portfolio value, NAV can take days to catch up.
This played out dramatically during the U.S. credit downgrade crisis in August 2011. HYG seemed to trade at a 2-3.5% discount between Aug. 4 and 8, as S&P downgraded the U.S. credit rating from AAA to AA+ on Aug. 5. Subsequently, HYG seemed to develop a premium on Aug. 9, when the Fed announced plans to keep interest rates low through 2013.
HYG’s market price initially responded by dipping below calculated NAV, followed by an overshoot on the upside. Yet as shown in the chart below, NAV was slow to update, as HYG’s price was the more reactive, or volatile, of the two series. HYG’s NAV lag was most dramatic on Aug. 9, as NAV continued to adjust downward while price reversed. NAV caught up on Aug. 12.
There were countless articles written about HYG’s apparent market malfunction. Yet HYG maintained excellent liquidity throughout the downgrade crisis. The real culprit was slow-to-update bond models that could not keep pace with real-time pricing. This can make for some unfortunate and unnecessary panic about premiums and discounts.
There’s one other way in which end-of-day premiums and discounts can appear extreme, despite a functioning arbitrage mechanism. This occurs even if NAVs are struck at 4 p.m. ET, with no synchronization issues; that is, in cases where iNAVs reflect intra-day values. It’s all about the timing of the last trade in the ETF. If the last print in the ETF happens many hours before 4 p.m., the ETF NAV and last price can drift apart. That’s exactly what happened with VETS.
This chart uses FactSet’s proprietary closing price database, which reflects the actual last trade. Zero volume days carry over pricing.
VETS’ premiums and discounts look huge but seem to narrow on high-volume days. On May 10, when VETS traded 3,750 shares, its closing premium/discount was 0.00%.
Contrast this with July 25, when 606 shares traded, and the day’s closing price was based on a 199-share trade executed at 12:13 p.m., at $26.31. VETS’ closing NAV that day was $26.50. This timing mismatch (noon vs. 4 p.m.) created an end-of-day discount of 0.72%, or $0.19.
Between NAV synchronization issues, NAV valuation discrepancies and trade timing mismatches, there are many cases where iNAV and end-of-day premium/discounts tell a misleading story. It’s easy to see why Nadig and other industry participants are eager to dispense with iNAV, and to flag problematic premium/discount results.
At the time of writing, the author held no positions in the securities mentioned. Elisabeth Kashner is director of ETF research and analytics for FactSet.