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By Paul Justice, CFA | 08-18-2011 11:39 AM

Bond ETFs Holding Up Well

Premiums and discounts spiked for some illiquid funds, but the broad-market fixed-income ETFs performed admirably during the recent market volatility, says Morningstar's Tim Strauts.

Paul Justice: Hi there. I'm Paul Justice, director of exchange-traded fund research in North America for Morningstar. At the beginning of August, we saw an outbreak of volatility that gave people flashbacks to October of 2008. Now, luckily the VIX only went as half as high as it did back in that timeframe, and things have seemed to settled down a bit since. But now it's time for us to look back, reflect, assess the damage, or even the lack thereof.

Today, I'm joined by Tim Strauts, one of our ETF analysts covering the fixed-income space, and he's going to give us a report card on how fixed-income ETFs performed during that timeframe.

Tim, thanks for joining me.

Timothy Strauts: Good to be here.

Justice: So, we saw some structural problems in the past with bond ETFs. They typically get to wider premiums and discounts when we see a bout of volatility. Could you talk about why that tends to happen more frequently with fixed-income ETFs as opposed to, say, the S&P 500 or other large-cap equity funds?

Strauts: Well, there's two main reasons. For one, with bond ETFs, the market makers who trade in the ETFs, who are the ones who are making the active markets every day, when there's a bout of volatility, they can only do a creation or redemption at the market close, but they're doing trades throughout the day.

Well, if they were doing S&P 500, if they're making trades, they can hedge this risk for a few hours with stock index futures, things like that. But in the bond market, there's not as many good ways to hedge intraday on your risks. So, what you do when there's a volatile period? You widen out your spreads.

Justice: So you make sure that you're mitigating the risk that you're taking by probably making more profit?

Strauts: Yes.

Justice: When you're buying, you're buying lower; when you're selling, you're selling higher. But what that typically going to mean is that we don't have great price discovery, either on the underlying bonds or perhaps on the ETF. Could you talk a little bit about that?

Strauts: Yeah, also when we calculate our net asset value, we calculate our premium discount. So, net asset value is based on fair value pricing. Well, fair value pricing is done because a lot of bonds don't trade every day, so you have put a value..

Justice: And they're not on an exchange, they're typically still over the phone. So, you don't have a great ticker that shows you what the prices are.

Strauts: Yeah, it's on the over-the-counter market. So, prices don't move as much, and so the fair value pricing makes it difficult sometimes, because the fair value pricing is slower to react to volatile markets. So, with the fair value pricing, if it's real volatile market, the market may come down a little bit, but then the active participants in the market who are trading it see it as a much bigger change, and they'll mark the bond ETF down further. So, that's why you tend to see these discounts because the bonds really are worth less, but the fair value pricing is kind of slow to react to that change.

Justice: Now investors may become accustomed to higher volatility in the markets, but the ETF itself has matured, especially in the fixed-income space as compared to just two years ago. We've got a lot more assets under management, the products have been around longer, and the market makers kind of understand them better. Could you give us a performance update, particularly how some of the fixed-income segments in ETF land held up during this recent bout of volatility compared with the past?

Strauts: I think, overall, it has definitely improved because we used to see much higher discounts show up in these volatile times, but overall things went well. For the aggregate bond ETFs the BND and AGG, the very popular, the largest, broadest, you can't really see much effect. It really doesn't always show up.

Really, the biggest change is if you look at the more illiquid sectors of the market. The most illiquid sector of the bond market is probably high-yield corporate bonds and the municipal bonds. In those two spaces, in high yield we saw on Monday, Aug. 8, which is the first trading day after the S&P downgrade, high yield had discount of 3.6%, and municipals got to discount of 3%.

Justice: So, this is really wide because typically we're not looking at much of a discount or premium at all on ETFs; that's at least the promise of them.

Strauts: Yeah, that is very wide. I would say is that in October 2008 it was wider. So, things are better. But we're seeing very illiquid markets, so the spreads widened out and this is also place where the fair value pricing is the worst because in high-yield bonds and municipals the fair value pricing doesn't work too well in these volatile markets.

If you looked at some other areas like emerging-markets debt, which in the past was usually one of the worst venders for large discounts, it actually wasn't too bad because it was only 1.3%.

Justice: Do you think that was because there is more interest in emerging-markets debt now than there had been in the past because we're still dealing with the timing difference; I mean those markets are pretty far away.

Strauts: Yes. I just think that in the last few years that emerging-markets debt has become more liquid. It's become more a popular asset class; you can see it in the fund flows and into the emerging-markets fixed-income ETFs. There is lot more money going into the space mainly because of all the sovereign debt problems of the U.S. and Europe.

Justice: Great. So, we're seeing more efficiency as the popularity increases and people are learning to adapt their practices to bring this ETF prices more in line with what the indexes are saying.

Strauts: Yes.

Justice: Well, thanks for your insights today. Thank you for joining us for this and more ETF information; please be sure to check out one ETF Investing Center on Morningstar.com and our ETF investor newsletter.

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