Lifting the Hood on Bond-Fund NAVs

Question: I understand how net asset value is calculated for equity funds because I can look and see how various holdings are performing in the market. But how is it calculated for bond funds given that bond prices are often less transparent?

Answer:  You've hit on an important difference in understanding how equity and bond funds operate. As you mention, calculating net asset value, or NAV, for an equity fund is a fairly straightforward process. You simply total up the end-of trading-day value of all the fund's assets, subtract out expenses such as the manager's salary and administrative fees, and divide the result by the number of fund shares outstanding. Because stocks owned by mutual funds typically are traded on exchanges and are fairly liquid--meaning shares are traded frequently and therefore pricing is updated often--it's easy to know how much each position in the equity fund's portfolio is worth. 

Calculating the NAV of a bond fund, on the other hand, isn't always so easy. That's because some bonds trade far less frequently than stocks, making it more difficult to determine their value.  

Entering the Matrix
Not all bond types have this problem. For example, U.S. Treasury bonds are traded heavily every day, giving funds that own them updated information about how much the bonds are worth. But other bond types might only trade every few weeks, making it harder to determine their value on a day-to-day basis. These more thinly traded bonds are often referred to as being less liquid than stocks and Treasuries in that it can be more difficult to find someone willing to buy them.

To deal with the problem of pricing less liquid securities, fund companies often turn to third-party pricing services. If a bond hasn't traded that day, and therefore no current price is available, the pricing service uses a system known as a pricing matrix, which takes into account factors such as the bond's type, issuer, rating, coupon, and maturity to arrive at an estimated price. By using more recent trading prices for bonds with similar characteristics, the matrix produces an estimated value for the bond. So if a bond hasn't traded in weeks, but another bond with a similar profile traded just yesterday, the price of this second bond helps determine an estimated value for the first.

Bond ETF Premiums and Discounts
One complication that arises as a result of this system involves fixed-income exchange-traded funds. Unlike traditional open-end bond funds, in which share price is determined by the net asset value of the underlying holdings, an ETF is traded on the open market, meaning that the price paid for a share of an ETF can deviate from the net asset value of its underlying holdings. Although this is also possible for stock ETFs, the fact that most stock prices are highly transparent helps keep the difference between an equity ETF's share price and its net asset value more or less in line with one another. That's not necessarily true for bond ETFs, however, especially those that traffic in thinly traded securities

Morningstar ETF analyst Tim Strauts describes in this article how the degree to which an ETF's share price and its NAV deviate tends to vary based on asset class. He found that in 2010, the average equity ETF with more than $100 million in assets and an average daily trading volume of more than 100,000 shares had a price that deviated from its NAV by just 0.08%. But for bond ETFs of the same asset size and trading volume the deviation was more than 3 times greater at 0.26%.

Strauts also found that the extent to which a bond ETF's NAV and share price deviate is correlated to the type of bonds in the portfolio and their degree of liquidity. For example, for ETFs that invest in U.S. government bonds, which trade frequently, the amount of deviation averaged just 0.07%, but for ETFs investing in municipal bonds, which trade less often, the average was 0.31%, and for ETFs investing in high-yield bonds, which can be highly illiquid, the level of deviation averaged 0.61%.  

Some ETF investors might look at this difference between a bond ETF's price and its NAV and conclude either that they are being ripped off (if the bond ETF they own trades at a discount to its NAV) or that they are getting a good deal (if it trades at a premium to its NAV). However some ETF proponents argue that a bond ETF's price is the more reliable gauge of the value of its underlying portfolio of bonds because the price is set by the market throughout the trading day whereas the NAV is more of a hypothetical calculation using a matrix pricing system that may not accurately reflect what the holdings are worth. (On Morningstar.com's ETF Quote pages, you'll find both share price and NAV as well as the degree to which the ETF is selling at a premium or a discount.)

In most cases, investors need not worry about ETF discounts and premiums to NAV. However, when dealing with ETFs that hold less liquid or exotic securities, it's best to keep an eye out for potential signs of trouble, as Morningstar ETF analyst Mike Rawson explains in this article. 

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