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By Paul Justice, CFA | 05-25-2010 12:28 PM

What's Behind Bond ETF Discounts?

Morningstar's Paul Justice and Bradley Kay look at price differences between fixed-income ETFs and their underlying indexes.

Paul Justice: Rising volatility in the equity markets has spread over to the bond markets in recent days.

I'm Paul Justice, director of ETF research at Morningstar. Today I'm joined by Bradley Kay, and we're here to talk about the contagion effects of volatility across these asset classes.

Bradley, today we see some price dislocations, especially in the ETF space. We're seeing indexes that are posted on ETFs that are higher than what the ETFs themselves are trading at. Can you dive into a little bit of detail and tell investors why they should expect such phenomena?

Bradley Kay: Absolutely. We're seeing a pretty big discount, and in particular it seems to be on the U.S. credit indices. So if it's investment-grade corporate bonds, or especially on high-yields bonds, we're starting to see discounts open up, not too large, only in, say, the 1% to 2% range.

But it really seems to be an issue of, there are some credit fears coming through, and that's causing some selling on the ETFs.

Justice: Now the index itself, though, is not coming down nearly as much. Can you explain why this tracking error is emerging with the ETFs compared to the index?

Kay: No. A large part of that comes from some of the volatility that can occur in the fixed-income market that actually gets disguised in the indices. A lot of this comes from how they're priced. When they do the prices, they are, say, taking a bid price and an ask price that's out there on the fixed-income market, and they then take the midpoint of that as the price.

Now when you get great uncertainty or when there's a lot of selling in the market, what happens isn't necessarily that that midpoint moves a tremendous amount. Instead, you just get the spreads widening.

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