What's Behind Bond ETF Discounts?

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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Justice: So there's no trade actually taking place in some instances, but you're making believe that a trade did happen there.

Kay: Exactly. So it's using a lot of midpoint prices that may not actually be real. If you want to actually sell, you're probably selling at, say, a 2% discount to that price in order to get the bond off your hands and into someone else's, or you're buying at a 2% premium. That's what can cause some of these ETF dislocations that we saw.

Justice: Sure, because right now we're seeing the ETFs trade. We're getting a lot of activity going on, and the bid-ask spreads on those are very narrow. Some of the examples we looked at were just one penny.

Kay: Indeed. I think that is one of the greatest indicators that actually the true prices you're seeing are on the ETFs and not on the underlying bonds and not on the underlying indices.

When you see spreads where people are willing to buy for one penny less than they are willing to sell at, that means that they are very certain that there's a fair value somewhere there in the middle. One of the widest spreads we saw was on HYG, and that was only about four pennies, the really large junk-bond indices and investment-grade bond indices.

That indicates that what we're seeing out of the indexes probably isn't the actual prices. The actual prices are being determined more by the ETFs.

Justice: So we're having price discovery in ETFs, not so much on the index, because when liquidity breaks down it's not a great indicator of what that basket is actually worth.

But if I'm a mutual fund holder, at the end of the day I'm going to get some price, and it's probably going to be higher today than it would be with the ETF. Does that lead to any conclusion or any opportunity for investors?

Kay: Exactly. We saw this occurring, actually, in December of 2008, when a very similar event occurred. Everyone was trying to sell of their junk bond holdings. Everyone was trying to sell off their corporate bond holdings.

You saw large discounts open up for a day or two on the ETFs. Actually, there was a great opportunity. Vanguard was one of the clearest ones, because this is the same pool of securities that they hold for both their ETF and their mutual fund.

Justice: Sure, it's a separate share class from the mutual fund, so it's the same exposure.

Kay: They hold the exact same trust. They hold the exact same legal trust-worth of shares, but if you sold off the mutual funds and bought into the ETF, at the end of the day you would get basically that 2% to 3% discount for free.

Justice: So you have the same pool of securities. You just had a pricing differential because one trades during the day and one does not. So what you have to be willing to do is ride out this bout of volatility until the markets stabilize once again.

Kay: Exactly. In some cases, it can end up hurting the mutual fund shareholders who do stay, because money is leaving at that higher NAV, which may not be based on true trade prices. Some of that may be money that then gets lost in the future as they try and actually sell off those bonds to make whole the shareholders who pulled their money out on that day.

So you can actually get a bit of the short end of the stick for the existing mutual fund shareholders who don't sell out when these things are trading lower than they should be.

Justice: So the investment vehicle, it can't hide the detriments of the underlying market. Fixed-income securities are volatile right now. The mutual fund may mask some of the intraday activity, but it's still volatile within there. The ETF merely shows it throughout the course of the day.

Kay: Exactly.

Justice: Great. Well, thank you for those insights, and we'll be looking more into some of the market anomalies over the course of the next few days. Thank you for joining us. I'm Paul Justice for Morningstar.