Discounts Disappearing On Bond ETFs

October 20, 2008

Investors can see the differences between closed-end funds and ETFs quite clearly after just four days of trading as discounts arbitraged away. 


The fire sale on bond exchange-traded funds appears to be quickly winding down.

Heading into Monday, ETFs focused on almost all categories were trading at significantly less of a discount than at the beginning of last week. In fact, many are now selling at premiums. (See chart below.)

That means investors who were looking forward to taking advantage of bargains usually only available in closed-end fund markets will be disappointed this week.

Of course, veteran portfolio managers and advisors have been cautioning investors about trying to play ETFs like closed-end funds. (See previous story.)

The two are very different animals. Closed-end funds typically only sell new shares through an initial public offering. As a result, as existing shares are sold on exchanges, their underlying bond issues don't always line up with their overall portfolios' net asset values.

ETFs, on the other hand, are open-end funds and can issue new shares at any time. But unlike traditional open-end mutual funds, ETF shares can only be created and redeemed through institutional investors buying in large lots.

If underlying prices get too out of whack with NAVs, such a unique creation/redemption process is designed to provide incentives for market participants to profit by arbitraging individual pricing back to the value of the total basket of bonds.

But in the chaotic conditions of the global credit crisis, such arbitrage activity came to a screeching halt in recent weeks. As a result, market observers say that institutional investors have had their hands full of late. They also pointed to problems with valuing bond issues under current conditions.

But several developments have eased liquidity concerns across fixed-income markets in the past week. The London interbank offered rate, or LIBOR, reversed course and started falling from historically high levels. That's important since the drop-off shows that banks are lowering the rates they're charging each other.

Also, regulators in the U.S. and Europe expanded their bailout efforts, pumping money directly into wobbly financial institutions, and in some cases, buying shares outright.

How much were markets impacted as represented by bond ETFs? Consider that:

  • High-yield bonds, referred to as "junk," and selling at double-digit discounts last week, now are trading at premiums in some cases. Most noticeable was the iShares iBoxx High Yield Corporate Bond ETF (AMEX: HYG). It had a discount of nearly 28% just four trading days ago; it enters this week with a premium of more than 3%, according to Morningstar data.
  • Broad bond ETFs taking a total market approach such as iShares Lehman Aggregate Bond Index (AMEX: AGG) fell from a better-than 8.8% discount to a discount of more than 2.3%. Even the relatively lightly traded Vanguard Total Bond Market ETF (NYSEArca: BND) dropped from a nearly 2.5% discount to a slight discount.
  • Several of the more popular muni bond ETFs, which are offering historically high yields in still-highly illiquid markets, are still trading with rather hefty premiums. But some recent expansion in supply, most notably a multibillion-dollar issue of new notes in California, is dropping those pricing bubbles. For example, the PowerShares Insured California Municipal Bond ETF (AMEX: PWZ) was trading with a premium of 9.73%; that's down to 1.88% this week. And the iShares National Municipal ETF (AMEX: MUB) is now selling for a premium a bit greater than 1%.





Discount/Premium (%)

iShares Lehman 7-10 Yr Treasury


Long Gov.


iShares Lehman 20+ Yr. Treasury


Long Gov.


PowerShares 1-30 Ladd. Treasury


Long Gov.


Vang. Ext. Dur. Treasury


Long Gov.


SPDR Lehman Long Treasury


Long Gov.


SPDR Lehman Int. Treasury


Inter. Gov.


iShares Lehman 1-3 Yr Treasury


Short Gov.


Vanguard Total Bond Market




iShares Lehman Aggregate




SPDR Lehman Int'l Treasury




Vanguard Intermediate -Term




iShares S&P National Muni


Long Muni


Vanguard Long-Term Bond


Long Bond


SPDR Lehman New York Muni


NY Muni


SPDR Lehman Calif. Muni


Calif. Muni


PowerShares Emerging Market


Emer. Mkt


iShares iBoxx Investment Grade


Long Corp.


PowerShares Insured Calif. Muni


Calif. Muni


PowerShares Insured NY Muni


NY Muni


iShares iBoxx High Yield Corp.


High Yield


PowerShares Insured Nat'l Muni


Long Muni


SPDR Lehman High Yield


High Yield


PowerShares High Yield


High Yield


Source: Morningstar Inc.























































































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