Bond ETF Premiums Become Discounts

Bond ETFs are something of a strange duck. As fixed income instruments packaged into an equity vehicle, they exhibit certain quirks unseen in either pure equity instruments or individual bonds.

One of these quirks is that, generally speaking, bond ETFs tend to trade at a premium to their net asset value (NAV). Not all bond ETFs do this, of course, nor do they trade with premiums all the time. But if you look at a typical bond ETF under typical market conditions, then chances are it'll be trading slightly higher than its NAV.

These are not typical market conditions, however. Over the past week and a half, equity markets have gone into freefall, market volatility has skyrocketed, and liquidity across asset classes has dried up. In addition, many bond ETFs have now started trading at persistent discounts to NAV, not premiums—some of which are quite substantial. (Read: "Why Many Bond ETFs Now Trading At Discounts.")

For example, on Tuesday, March 18, we saw eight of the 10 largest bond ETFs trade at discounts to NAV:

To understand why these discounts emerged, or why bond ETFs usually trade at premiums, you have to understand how NAVs for bond ETFs are calculated.

How Bond ETFs Calculate NAV

Broadly speaking, the NAV for any given ETF is the sum of all its assets (i.e., the value of the individual securities in its portfolio, plus any cash or derivatives holdings) minus its liabilities (like management expenses), all divided by the total number of shares outstanding. (Read: "Understanding Net Asset Value.")

How those individual portfolio securities are valued is a complicated matter, varying from asset to asset. For stock ETFs, it's fairly easy; with some exceptions, the stocks' closing auction prices are used.

In the case of bond ETFs, there are three choices on which price to use for individual bonds:

• the bid price (what buyers want to pay for the bond),
• the offer price (what sellers want to receive for the bond),
• the midpoint of the two

One key thing to remember: The bid is usually the lowest price, while the offer is usually the highest price. (Read: "Understanding Spreads And Volume.")

Most bond ETFs use the bid prices of their individual holdings to calculate the fund's overall NAV, though a few use midpoint prices.

The difference between bid and mid is usually only a matter of cents, or even fractions of cents, but it can substantially impact how a bond ETF trades. A hypothetical ETF that valued its holdings based on their bids would tend to trade higher than a hypothetical ETF with the exact same holdings using the midpoints—by a factor of one-half (which makes sense, since the midpoint price is just that: halfway between bid and offer).

The Difference Bid Or Mid Makes

Of course, hypotheticals are easy. Bids and offers change constantly, and the spread between them can grow larger or smaller depending on various factors, including how many people want to buy and sell at any given time. (Read: "Why Trading Spreads Matter For ETFs.")

Let's say that markets are rip-roaring, as they were recently, and there are more buyers than sellers for a given bond ETF. If that bond ETF is 'bid-marked'—that is, it uses bids to value its underlying holdings—then it will likely start to trade at a premium above NAV.

That's because authorized participants (APs), whose job it is to create and remove ETF shares from the marketplace, will need to start creating more ETF shares to meet demand. To do so, they'll have to buy more bonds—usually at the higher offer price—thus nudging up the ETF's NAV; hence why most bond ETFs—which are bid-marked—have tended to trade with premiums. 

If there are more sellers than buyers though, a bid-marked ETF won't necessarily start trading at a discount. When there are more sellers than buyers, APs will remove ETF shares from the marketplace by redeeming them for the underlying bonds, which they can then sell for the same bid price that the ETF was using to calculate NAV. (Remember: Bid prices are lower than offer prices.)

How To Price A Bond When It Isn't Trading

In this latest round of market volatility, however, we have seen bid-marked bond ETFs trade with substantial discounts to NAV, even though theoretically they should be trading nearer to NAV. What gives?

Again, this comes back to the machinery of ETF pricing. Bonds don't trade on exchanges like equities do: They trade over-the-counter, and there's no standardization or wide dissemination of buy-and-sell orders. Instead, would-be bond traders must go to one of several electronic trading platforms or even set up trades on a case-by-case basis.

What's more, not every bond trades every day; for example, it's not unusual for individual corporate or muni bonds to go days without trading. But bond ETFs trade whenever the equity markets are open; they can't just not trade simply because their underlying constituents aren't trading.

So ETFs need "fair values," or best-guess estimates, for their underlying holdings, so they can calculate NAV. If there's no recent trade to base those fair values on, then index providers for bond ETFs will rely on dealers and bond pricing services to fair-value their holdings instead.

Therein lies the rub. Even in the best of times, fair valuing is something of an educated guess, but right now, bond pricing services are having a heck of a time coming up with fair values. Over the course of only a few days, liquidity has dried up in the cash market; all the buyers are fleeing, leaving only sellers behind.

As a result, accurately valuing individual bonds to calculate a bond ETF's NAV has become exceedingly difficult for pricing services to do. Even if they can manage to fair-value a bond ETF's underlying, those values are almost assuredly stale, lagging what they'd really be in the marketplace; hence why we're seeing ETFs trade at a discount to their NAV, which is based on these fair value estimates.

Time To Panic? No!

But here's where things get truly remarkable. Because bond ETFs continue to trade regularly on equity exchanges, even when their underlying fixed income holdings aren't trading, they've begun to act as a price discovery mechanism for their less liquid holdings. In other words, a bond ETF's price becomes a forecasting tool for where its NAV, and in turn its underlying bonds, ought to be valued.

What's more, by continuously offering the ability for buyers and sellers to find each other via equity exchanges, bond ETFs are actually adding liquidity to stressed bond markets. Buyers and sellers can continue to find each other and execute trades, even when they can't do so in the underlying cash bond market. That's a good thing!

Trading premiums and discounts happen in ETFs, fixed income or not. Usually they're temporary; sometimes they aren't. If you're worried about them, the best piece of advice we can give you is to make sure you always use limit orders when you trade, so that you don't end up paying more than you intend.

But discounts only come into play if you're trading ETFs. If you already own the ETF in question and have no intention to buy or sell, then you can just ignore the above 1,300 words and sit tight.

Contact Lara Crigger at [email protected]