The volatility waves of the coronavirus outbreak have reached every corner of the financial markets. For bond ETFs, the waves have led to both volatile market price fluctuations and above-average gaps between market prices and net asset values (NAVs). If the gap is positive (ie if the market price is higher than the net asset value), one speaks of a premium. A discount is applied if the net asset value is higher than the market price. While such gaps can be troubling, history shows that bond ETFs always have bonuses or discounts, and their expansion is short-lived given market volatility.
Bond ETFs are an important source of liquidity
Along with the increased market volatility in the bond market in the past week, the liquidity of many types of individual bonds has decreased, ie the willingness of market participants to buy and sell. Bond ETFs, on the other hand, have maintained their liquidity and were the main mechanism for pricing in bond markets.
In such a volatile environment, bond ETFs can be expected to trade at a discount or premium. Although discounts and premiums of this magnitude and range are rare, bond ETFs have been tested in earlier volatility phases and reflect the value of the underlying fixed income securities in real time. In times of volatility with rapidly developing macro, interest rate and credit environments, investors should expect premiums or discounts on bond ETFs. Bond ETFs that follow similar benchmarks have also seen large differences in market returns.
Fewer inputs can lead to larger price differences
Discounts and differences in performance reflect the fact that there are two ways to determine portfolio values. When setting end-of-day NAVs, ETF price specialists use both actual trades and an adjustment factor based on bid / ask spreads for bonds, especially for bonds that have not recently been traded. In contrast, market prices are determined jointly by ETF investors and “market makers”. If, as in the past week, bond trading in the underlying market is fairly restricted, the NAV calculations will have fewer inputs and therefore there is an increased likelihood of differences in market prices.
Unlike a net asset value calculated by a price provider, market prices for bond ETFs reflect the market’s minute-by-minute judgment, which includes factors such as:
- Market Maker valuation of underlying holdings.
- Supply and demand for the ETFs.
- The cost of providing liquidity in fast-moving markets where underlying bonds may have less liquidity.
Because these calculations have different inputs, investors should expect different results, especially in volatile markets. When viewed over long periods of time – for example, a month or a quarter – these short-term differences are generally imperceptible, since they extend over a “normal” day or a “normal” week.
In the past, premiums and discounts for bond ETFs were tiny
A typical example: More than 3,200 trading days with the Vanguard Total Bond Market ETF (BND)
Notes: The chart shows the frequency of premiums and discounts of various sizes between the market price and the net asset value of the Vanguard Total Bond Market ETF between the launch of the fund on April 3, 2007 and March 16, 2020. Premiums and discounts are based on end-of-day market prices and net asset values. On 2,940 out of 3,263 trading days – 90% of the time – the market price was between a discount of 0.2% and a premium of 0.4%. There were discounts of more than 0.2% in just 15 days.
ETFs as shock absorbers
Bond ETFs serve as an important source of pricing and a “shock absorber” for liquidity in relatively illiquid periods. Around 80% of trading in fixed income ETFs usually takes place on the secondary market, ie investors who trade ETF shares among themselves and do not initiate trading in the underlying securities. Trading volume of Vanguard bond ETFs has tripled recently, meaning that bond ETFs have been a real source of liquidity for all types of bond investors.
When comparing an ETF’s market price return to its return based on its net asset value, it can be misleading to focus on a single day or week as a relevant snapshot of performance. It is also worth noting that not all investors sell at (or in) the rebates, as market outperformance is a zero-sum game. In fact, investors on the other side of recent trades have bought at a relative discount.
In times of remarkable market volatility, we remind ETF investors: Avoid trading on or near the beginning and end of the trading day if possible and consider using limit orders that are only executed when the market price reaches a threshold of your choice or exceeds. And if you don’t have to act in a time of such volatility, don’t – this could be the best approach of all.
- Vanguard ETF Shares can only be redeemed in very large aggregates worth several million US dollars with the Issuing Fund. Instead, investors must buy and sell Vanguard ETF shares on the secondary market and hold those shares in a brokerage account. The investor can receive brokerage commissions and pay more than the net asset value on purchase and less than the net asset value on sale.
- Every investment is subject to risk, including the possible loss of the money you invest. Fluctuations in the financial markets and other factors can cause your account to lose value. There is no guarantee that a specific asset allocation or mix of funds will achieve your investment objectives or provide you with a certain level of income.
- Diversification neither secures a profit nor protects it from a loss.
- Investments in bonds are subject to interest rate, credit and inflation risks.
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