During the market meltdown, trading problems in bond exchange traded funds (ETFs) left huge discounts relative to net asset values (NAVs).

To find an answer to this phenomenon, Citi Investment Research generated a report focusing on specific intraday movements of bid/ask spreads and discount/premium levels for ETFs.

The study suggests that bid/ask spreads increase significantly across taxable and non-taxable bond ETFs, the discount/premium level was greatest compared to NAV in direct proportion to the level of corporate bonds held in a portfolio and that the basic creation/redemption relationship broke down as a result of iliquidity and the inability to leverage the ETF creation and redemption arbitrage opportunities, states Eric Rosenbaum for Index Universe.

To increase the accuracy of data and get rid of some of the common problems with pricing, Citi took the average of the discount or premium of the last price at the end of 15-minute intervals and for the study of discounts and premiums, Citi took broke the research up by specific weeks.

The data suggests in order to alleviate these problems and see greater liquidity and the discount to NAV gap diminish in the future, structural changes in the creation and redemption process could be needed. More specifically, by having fewer securities, more liquid securities, and a higher cash component in creation baskets.  Additionally, Citi recommends to increase flexibility of cash and in-kind redemptions and to reduce the minimum size to create and redem.

iShares Lehman TIPS Bond Fund (TIP): down 5% for the year; 7.06% yield.

iShares Lehman 1-3 Year Treasury Bond Fund (SHY): up 5.4% for the year; 3.38% yield.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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