As Arbitrage Falters, Bond ETFs Teeter

December 17, 2008

Comparing maximum premium/discount swings in different types of bond ETFs during the ongoing credit crunch reveals some surprising results.


Exchange-traded funds can be attractive alternatives to mutual funds and closed-end funds in important ways when market mechanisms work as intended.

However, bond ETF mechanics for several bond categories have broken down, making no-load and low-expense bond mutual funds currently more attractive than their ETF cousins.

No-load mutual funds work at net asset value, but ETFs with broken arbitrage mechanisms can trade at substantial discounts and premiums to NAV, much like closed-end funds.

ETFs were designed to solve the premium/discount problem of closed-end funds, and to provide intraday liquidity and shorting potential that is lacking with mutual funds.

It's a great idea when it works, but risk aware investors need to observe the premium/discount on ETFs to make sure the arbitrage mechanism that minimizes premiums and discounts is functioning.

Arbitrage is clearly not functioning properly for some bond types in this current difficult credit market. As a result, it might be better sticking with no-load and low-expense index mutual funds for those bond categories with broken ETF arbitrage.

Consider this table of ETF premiums and discounts for several bond index categories:


Click here to see a larger version of this table.


The above table shows the premium or discount history for Q3 2008 and for December 11, 2008. Green shading indicates expected premium/discount behavior. Yellow shading indicates unexpected, but perhaps tolerable behavior. Pink shading indicates unacceptable premium/discount behavior.

Percent Of Days Within Expected Premium/Discount Range

If the expected premium/discount of +/- 0.5% occurred for 90% or more of the days, the fund is shaded green. If the expected range occurred for 80% to 90% of the days, the fund is shaded yellow. The fund is shaded pink if the expected premium/discount range occurred for less than 80% of the days.

Only sovereign U.S. Treasuries, mortgage-backed securities (agency debt) and the aggregate bond (with lots of Treasury and guaranteed agency debt in it), earned green shading. Municipal bonds and non-U.S. investment-grade Treasuries earned a cautious yellow shading. Liquid-investment grade corporates, high-yield corporates and emerging market sovereign Treasuries pretty much fell off a cliff in terms of percentage of days within expected boundaries (44%, 11% and 3%, respectively).


Maximum Premiums And Discounts

We assigned a green shade to premiums or discounts that were within the expected +/- 0.5% range, a yellow if over 0.5% up to and including a 1% deviation from NAV and a pink for a premium or discount greater than 1%.

Only 1-3 year Treasuries stayed green in all periods.

All of the Treasury funds earned a green or yellow shade in all periods except for TIPS, which crept over the line to pink as of Dec. 11 with a 1.07% premium.

The investment-grade agency mortgage-backed securities ETF did surprisingly well with green and yellow. It includes agency debts that were not federally guaranteed at the beginning of the period, but were federally guaranteed by mid-period.

The municipal bond ETF had adverse conditions mostly to the premium side, ending Dec. 11 with a 3.59% premium. Interestingly, municipalities are in financial stress, California is running out of cash and MUB is trading at a premium. We'd rather buy munis at NAV in a mutual fund.

The aggregate bond ETF went for a roller-coaster ride ranging from a premium of 1.59% to a discount of 8.67%, but is within the expected green shaded range now.

Similarly, non-U.S. investment-grade Treasuries bounced around to plus and minus premiums, but are now at a 4.17% premium.

Liquid investment-grade corporates, high-yield corporates and emerging market Treasuries have been out of whack, including deep discounts of 11.34%, 7.95% and 4.21%, respectively. They are still out of whack, although emerging market Treasuries are approaching the tolerable yellow zone.


Trading Vs. Investing

If you want to play with risk premiums and discounts, these bond ETFs may be for you (e.g., AGG from 8.66% discount to 1.60% premium, and LQD from 11.34% discount to 2.80% premium). However, if you are a bond investor looking to be at or near NAV and you aren't looking for Treasuries, you need to be in no-load, low-expense mutual funds.


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