Study: Do Bond ETF Creations & Redemptions Work?

November 10, 2008

The study found that discount/premium levels were greatest compared to NAV in direct proportion to the level of corporate bonds held.

 

A new Citi Investment Research study looks closely into the trading problems in bond exchange-traded funds, where wide discounts opened up relative to net asset value during the worst weeks of the market meltdown.

The problems with bond ETFs have been much studied, but Citi's latest report took an interesting and timely look at specific intraday movements of bid/ask spreads and discount/premium levels for ETFs.

The primary conclusion of the Citi research is that bid/ask spreads widened significantly across taxable and tax-free bond ETFs, a trend that has been increasing across the entire ETF landscape (see story here.)

Furthermore, the discount/premium level was greatest compared to NAV in direct proportion to the level of corporate bonds held in a portfolio: the higher number of corporates, the wider the discount/premium level was, especially among high-yield ETFs.

Ultimately, Citi expects these problems to persist for bond ETFs in a way that the more-transparent equity markets will not experience even during the most abnormal markets. The Citi report also suggests that it could require structural changes in the creation/redemption process, allowing authorized participants to tighten markets at times when ETFs are straying from normal net asset values, to avoid similar scenarios for bond ETFs in the future.

Citi analysts believe the basic relationship between market makers and funds to keep tight markets broke down due to illiquidity and market makers' inability to leverage the ETF creation and redemption arbitrage opportunities in the less transparent, poorly priced bond markets.

The Intraday Approach

Typically, discounts or premiums to ETF net asset values are derived by technology vendors using the day's closing price versus net asset value or, in the case of fund company Web sites, the midpoint of the closing bid/ask spread versus NAV. During the worst days of the market turmoil, there was high volume trading at the end of the day on both the equity and fixed-income sides. ETF sponsors have also noted that trading can often tighten up or widen toward the end of the day, and therefore, the measure of a discount or premium can be overstated due to the use of the closing price and end-of-day NAV.

To provide a different data access point to bond ETF pricing problems, Citigroup tracked the discount or premium of the last price each 15 minutes throughout the day, as well as the midpoint between the bid/ask spread to the intraday NAV. Citi also averaged out the data for the day. Treasury-based ETFs and the one mortgage-based ETF were scrapped from the study due to lack of significant intraday variation.

On the taxable bond side, the largest differential between pre-market meltdown bid/ask spread and market crises spread in the selected ETFs studied by Citi was the PowerShares Corporate High Yield Bond Portfolio (NYSE: PHB), at 1.20%. Among tax-free ETFs, the SPDR Lehman New York Municipal Bond ETF (NYSEArca: INY), had the largest differential, at 1.0%.

The top five bid/ask spread differentials among taxable bond ETFs studied by Citi were PHB; PowerShares Emerging Markets Sovereign Debt (NYSE: PCY); iShares Lehman Credit Bond (NYSE: CFT); SPDR DB International Government Inflation-Protected Bond (NYSE: WIP); and iShares Lehman Intermediate Credit Bond (NYSE: CIU).

 

ETF

Thru 8/29 (%)

Since 9/15 (%)

Differential (%)

PHB

0.80

2.00

1.20

PCY

0.40

1.50

1.10

CFT

0.40

1.30

0.90

WIP

0.10

0.60

0.50

CIU

0.20

0.60

0.40

 

The SPDR Lehman High Yield Bond (NYSE: JNK); iShares JP Morgan USD Emerging Market Bonds (NYSE: EMB) and SPDR Lehman International Treasury Bond (NYSE: BWX) were also tied for the fifth-largest differential among taxable bond funds studied by Citi, at 0.40%.

The top five pricing differentials among tax-free bond ETFs were INY; SPDR Lehman California Municipal Bond (NYSE: CXA); iShares S&P California Municipal Bond (AMEX: CMF); iShares S&P New York Municipal Bond (AMEX: NYF); and Market Vectors AMT-Free Long Municipal (AMEX: MLN).

 

ETF

Thru 8/29 (%)

Since 9/15 (%)

Differential (%)

INY

0.60

1.60

1.00

CXA

0.60

1.40

0.80

CMF

0.30

1.00

0.70

NYF

0.30

1.00

0.70

MLN

0.30

0.80

0.50

 

Find your next ETF

Reset All