As the popularity of exchange traded funds (ETFs) grows, more and more market observers are now focused on the generally persistent fixed-income funds’ premiums and discounts, or when the ETF’s trading price diverges from its calculated net asset values (NAVs).
Matthew Tucker and Stephen Laipply for IndexUniverse discuss the framework of fixed-income ETF premiums and discounts and how investors may evaluate the funds to maintain efficient trades. There are a few factors that affect premiums/discounts and liquidity, including the value of the underlying portfolio, level of ETF supply and demand in the secondary market, costs of share creation and the amount of volatility and liquidity in the fixed-income market.
Arbitrage as conducted by authorized participants helps to keep ETF prices relatively close to the value of the underlying securities. Premiums or discounts may linger in an ETF if it is not large enough to trigger an arbitrage opportunity. Creation costs, or the cost of originating new fixed-income ETF shares, is the largest factor in fixed-income ETF premiums, depending on the creation methodology used by the ETF, which are usually either the in-kind method or cash-create method. [The ETF Creation and Redemption Process Explained.]
- The in-kind methodology is where a broker/dealer delivers bonds to the ETF provider in exchange for ETF shares, and costs would be associated with acquiring the bonds in the underlying market. Over time, liquidity changes, along with transaction costs, which leads to greater creation costs and the level of the ETF premium. The cash-creation methodology is where a broker/dealer delivers cash to the fund provider for new shares. The premium for cash-create funds may be lower than in-kind creation since they are dealing in cash. However, by this method, transaction costs are less transparent since the costs are embedded in the ETF’s performance.
- The secondary market provides another “layer” of liquidity for ETFs, and may allow ETF trades to be executed at tighter bid/ask spreads than the underlying market. However, stressed and illiquid markets may result in higher execution risk adjustments, which can cause wider price deviations from bid-side NAVs.
- Lastly, timing difference in the time when a fund NAV is calculated and when the ETF trading day ends affects fixed-income premiums and discounts. Since fixed-income ETF’s underlying portfolio is valued at 3 p.m. ET and the ETF continues to trade till 4 p.m., movements may occur and discrepancies could occur, producing premium or discounts to NAV.
Kevin Grewal for TheStreet opines that Treasury bond ETFs such as iShares Barclays 1-3 Year Treasury Bond (NYSEArca: SHY), iShares Barclays Short Treasury Bond (NYSEArca: SHV) and iShares S&P/Citi 1-3 Yr International Treasury Bond (NYSEArca: ISHG) are heading toward bubble territory. Treasury prices are rising and yields are falling, but investors are still flocking to this asset class. Still, the Fed will have to eventually increase rates and bonds would become less desirable. Additionally, the copious federal deficit may also eventually push up inflation, which threatens to diminish yields and real returns of bonds.
Other investment analysts also believe that the bond-fund bubble will soon burst, with U.S. Treasuries taking the brunt of the blow, writes Mark Trumbull for The Christian Science Monitor. According to the Investment Company Institute, investors were pulling out of stock mutual funds and funneling the cash into bonds. With all the volatility still out there, bond funds are still enjoying a rather bullish outlook and could continue to do so unless the economy shows a signs of a strong recovery. [The Renewed Rush for Bond ETFs.]
For more information on bonds, visit our bond ETFs category.
Max Chen contributed to this article.