Where Are Bond ETF Premiums & Discounts Heading?

February 20, 2009

The ongoing credit crisis has revealed some startling facts about what types of risks investors face when dipping into low-quality credit waters.

 

Among the worst performers during the ongoing credit crisis have been the lowest-quality bond issues and the exchange-traded funds that hold them.

Credit quality, credit risk and credit liquidity problems were completely reflected in bond ETFs through their total return and premium/discounts to net asset values.

If in the near future the market volatility subsides and credit becomes more available, it makes sense that bond ETFs will begin to experience more liquidity and be able to reflect more closely the prices of their underlying holdings. 

As this happens should we expect the premiums and discounts of bond ETFs to settle to normal levels?

Taking A Look At Junk's Characteristics

High-yield bond ETFs are among the most volatile bond funds, experiencing drastic sudden price decreases, along with alarming discounts to NAV. Meanwhile, they faced the brunt of the flight to quality among investors. Shown below is the return from November 14, 2007 through February 17, 2009, data from Morningstar.

 

Growth

 

The graph above of three high-yield bond ETFs tells the story well of the turmoil during the fourth quarter of 2008. During this time bond ETFs saw huge discounts to their net asset values (NAV).  Slight premiums and discounts to NAV are common to all ETFs since ETFs trade separately from the NAV at market values. 

Bond ETFs have a tendency to normally trade at greater bands around their net asset values due to liquidity and fair pricing issues in the underlying bonds.

There has been a lot of debate and research done to examine whether bond ETFs can function properly -- that is, follow the price of their underlying bonds. 

The problem this time turned out to be stale prices in the underlying bonds. And interestingly, the bond ETFs -- which at the time were trading shockingly lower than their net asset values -- were acting as price discovery mechanisms.

In short, the market during some of the worst parts of the credit crisis was reflecting the price of the underlying holdings in the ETF, even though there was close to no trading or price-setting over the exchange for the individual bonds. 

Heather Bell, in her article, "Bond ETF Spreads Cause Concern," published in the December issue of ETFR, explains the spread issue fully with many experts' options on the issue.

The Spread Between Bond ETFs 

In the graph below is the problem high-yield bond ETFs faced, separating from their NAV values in huge percentages during the worst times. 

The discounts represented by negative values shows a risk not often thought of when investing in ETFs, the potential for the market price to not reflect the value of the underlying basket of securities. 

In the case of bond ETFs most recently, it appears that the ETF market prices did in many ways reflect the value of the underlying holdings where the NAV could not.

 

Premium/Discount: As Percentage of NAV

 

The analysis of the overall bond ETF market -- finding each specific thing that worked and did not work during the period in 2008 where bond ETF spreads were at their extremes -- is difficult, to say the least. But most bond ETFs, especially the three high-yield funds, are passive investments with no manager risk. This has appeal for several reasons to variety kinds of investors at various levels of market participation.

The concern is whether the execution of the bond index worked and will continue to work in the future.  Since ETFs depend on market makers taking advantage of premiums and discounts to NAV, the underlying liquidity and pricing is always a concern and will be no matter if an investor owns the bonds through an ETF or directly.

The question is whether high-yield ETFs will soon return to trading around normal bands about their NAVs.  As we see in the graph, all three high-yield ETFs have been getting closer to trading nearer to NAV but have yet to return to long-term averages. 

This may be the result of market conditions remaining volatile and weary of credit risk.

In the above graph, it is obvious that the PowerShares ETF, PHB, which has an average credit quality similar to the two other ETFs, displayed the largest discount to NAV during the month of September in 2008.  Each of the high yield ETFs, despite being similar in quality and other features, track there own indexes, which hold completely different underlying bonds. 

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