Practical Ways To Hold Down Costs With Bond ETFs

August 06, 2009

 

Munis Tell The Tale

The municipal bond market is notoriously illiquid. As a result, ETF providers have taken different approaches to launching municipal bond ETFs, with some offering traditional in-kind creations and others offering APs the ability to do “cash creates.” In a “cash create,” an AP delivers cash to the fund in exchange for shares, rather than buying up the underlying holdings of the fund itself and delivering that basket in return for shares.

For this study, we examined the returns of 16 muni bond ETFs: three from Invesco PowerShares, four from Barclays Global Investors, four from State Street Global Advisors and five from Van Eck. Of the 16 funds, five use the traditional “in-kind” creation/redemption methodology: the four iShares funds from BGI and the Market Vectors High Yield Muni ETF (NYSE Arca: HYD) from Van Eck. The remaining 11 funds use a cash creation process, although they still rely on in-kind redemptions.

The data are unequivocal—cash creations work. The five ETFs that use in-kind creations had average premiums and discounts between 0.79% and 2.82%. They traded at a premium every day of the second quarter. For the cash creation funds, average premiums and discounts varied between just 0.015% to 0.56%. Moreover, those premiums and discounts varied, with all of the funds experiencing both premiums and discounts, and one fund – the Market Vectors Long Muni ET—trading at a discount more than 65% of the time.

 

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

IN-KIND CREATIONS

S&P California Municipal Bond Fund

CMF

1.72%

100%

3.14%

0.18%

S&P National Municipal Bond Fund

MUB

0.79%

100%

1.68%

0.17%

S&P New York Municipal Bond Fund

NYF

1.59%

100%

5.37%

0.25%

S&P Short Term National Municipal Bond Fund

SUB

2.82%

100%

4.26%

1.91%

Market Vectors High Yield Muni

HYD

1.90%

100%

3.74%

0.15%

CASH CREATIONS

SPDR Barclays Capital
California
Municipal Bond ETF

CXA

.51%

90%

1.36%

-.52%

SPDR Barclays Capital Municipal Bond ETF

TFI

.11%

79%

0.52%

-.51%

 

SPDR Barclays Capital
New York
Municipal Bond ETF

INY

.015%

52%

4.14%

-3.37%

SPDR Barclays Capital Short Term Municipal Bond ETF

SHM

.09%

97%

0.39%

-0.06%

Market Vectors Pre-Refunded Muni

PRB

.24%

76%

1.61%

-0.45%

Market Vectors Short Muni

SMB

.56%

95%

1.95%

-.3%

Market Vectors Intermediate Muni

ITM

.38%

92%

.92%

-.82%

Market Vector Long Muni

 

MLN

-.25%

35%

1.20%

-2.03%

PowerShares Insured National Municipal Bond Portfolio

 

PZA

.19%

89%

1.23%

-.30%

PowerShares Insured
New York
Municipal Bond Portfolio

 

PZT

.06%

70%

0.81%

-.23%

PowerShares Insured
California
Municipal Bond Portfolio

 

PWZ

.15%

78%

1.18%

-.36%

 

The cash creation data, together with the data showing tighter premiums and discounts in more liquid markets, argue against the notion that these funds are providing price discovery. The premiums and discounts that occur in most bond ETFs are driven by the illiquidity of the underlying bonds. If you remove that illiquidity either by focusing exclusively on liquid markets or using a cash creation mechanism, the premiums and discounts largely disappear.

Note, of course, that a cash creation will not prevent a fund from trading at a discount. All of these funds do in-kind redemptions—if an AP wants out, they’re getting a pile of individual bonds in return, not a check—which means the funds are still exposed to the potential for trading at a discount.

 

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