An article from the latest issue of the Journal of Indexes: Are bond ETF prices accurate or are they subject to investor demand?
[This article appears in September/October 2010 issue of the Journal of Indexes.]
Over the past decade, the ETF market has expanded both in terms of assets and market coverage. Investors can now choose from a wide variety of equity, fixed income and alternatives markets through ETFs.
The first fixed-income ETF was established in 2002. More than $160 billion is now invested in hundreds of funds listed on exchanges around the globe.1 As fixed-income ETFs have grown in popularity, a robust discussion has evolved with respect to how the funds trade on an exchange. In particular, recent dialogue has focused on the funds’ premiums and discounts, where an ETF’s trading price diverges from its calculated net asset value (NAV).
Some of this divergence can be traced to the mechanics that govern ETFs across all asset classes. The rest lies in how over-the-counter fixed-income securities behave when held in an exchange-traded instrument. In this paper, we develop a framework for understanding the drivers of fixed-income ETF premiums and discounts to help investors better evaluate these funds and achieve more efficient execution.
Premiums And Discounts
We begin by introducing the following factors that relate to premiums/discounts and liquidity:
- Value of the underlying bond portfolio
- Level of ETF supply and demand in the secondary market
- Cost of share creation through the underlying fixed- income markets
- Level of fixed-income market volatility and liquidity
Investors purchase and sell shares of ETFs on an exchange, trading them in exactly the same way as a listed stock. A share of an ETF represents partial ownership of the portfolio of securities in the ETF itself, much like shares in a traditional open-end mutual fund represent partial interest in the underlying fund holdings. What differs is the ETF’s creation/redemption mechanism.
During periods of strong demand for an ETF, the price of the shares is bid up in the market. If the ETF price is higher than the value of the underlying securities held within the ETF, an arbitrage opportunity may exist. Authorized participants (e.g., broker/dealers) could purchase the underlying fixed-income securities, create new ETF shares and then sell the newly created ETF shares in the market for a profit.
Conversely, this same set of mechanics operates in markets of strong selling pressure, to help keep the ETF from trading at a persistent discount. Authorized participants could purchase the ETF shares (at a discount), redeem them and then sell the fixed-income securities received from the redemption at a net profit. Arbitrage helps keep the ETF price in line with the value of the underlying securities. The premium or discount is calculated as follows:
Premium/discount = ETF market price - value of underlying securities
A premium or discount can exist and even persist for an ETF as long as it is not large enough to trigger an arbitrage opportunity. This means that the size of the premium/discount will be bounded by the transaction costs participants would incur in executing the underlying arbitrage transaction. As long as the premium or discount is less than these transaction costs, there is no economic incentive to execute the arbitrage opportunity.
The largest cost component is the expense to trade the underlying securities held by the ETF, as represented by their bid/offer spreads. This implies that an ETF can trade anywhere within the bid/offer spread of the underlying securities market. How much of this underlying market transaction cost is reflected in the ETF price is a function of trading flows. In balanced markets (i.e., symmetrical buy vs. sell orders), there is no need for authorized participants to access the underlying securities markets; therefore, only a fraction of the underlying market bid/offer spread is reflected in the price of the ETF. In unbalanced markets (e.g., excessive buy orders), the entire underlying bid/offer spread may be priced in.
This concept can be explained by defining the underlying bid/offer spread as the creation cost, and the balance of trading activity in the ETF as the flow factor.
Creation cost = bid/offer spread of underlying market