ETFs publish the net asset value, or NAV, of their underlying holdings throughout the day. When the ETF share price is below the NAV, the fund is said to be trading at a discount. When the share price is above the NAV, the ETF is trading at a premium.
ETFs have a complex arbitrage mechanism designed to keep the share price in line with NAV, so investors get fair prices when they buy and sell.
In illiquid markets, ETFs can trade at premiums or discounts to NAV in times of volatility or heavy buying and selling pressure.
However, in these cases, the deviations to NAV are not proof of a functional problem in ETFs or a breakdown of the arbitrage mechanism.
For example, there have been several media stories recently focusing on the discounts seen in bond ETFs, particularly funds tracking municipal bonds and high-yield corporate debt. The bond market has been under stress on rising interest rates and speculation the Federal Reserve may pull back on monetary stimulus.
Rather than any structural flaw, these “discounts” are actually a reflection that ETFs trade in real time throughout the day. During the recent sell-off, some muni and high-yield bonds simply stopped trading. Therefore, the fund’s NAV isn’t really an accurate indication of real-time value.
This issue is addressed in a 2010 paper by BlackRock fixed-income strategists Matthew Tucker and Stephen Laipply. BlackRock manages the iShares ETFs.
They focused on the 2008 credit crisis when liquidity dried up, and its impact on bond ETFs.
“Credit markets essentially froze, while fixed income credit ETFs continued to trade on the exchange,” the BlackRock strategists wrote. “In some instances, they were the only source of market exposure and price discovery.”
Next page: ‘It’s the correct price’
Some bond ETFs were faced with a similar situation during the recent sell-off. [Bond ETF Liquidity Risks: Facts vs. Fiction]
Going back to the financial crisis, “because the underlying market was impaired, ETFs were trading at a discount, as dealers struggled to mark positions and fund NAVs lagged the real time, intraday price discovery reflected in the ETFs,” BlackRock explains.
In fact, some bond ETFs traded at premiums to NAV in late 2008 with many investors trying to reestablish positions in credit markets “as dealers continued to wrestle with price discovery and valuation of bonds that, in some instances, were not trading,” the fixed-income strategists said.
“Because they are exchange-traded instruments, ETFs continued to trade throughout the crisis, providing price discovery in an underlying market that had become highly illiquid. As liquidity was gradually restored to the credit markets, the execution risk adjustment declined, and premiums reverted to more historic levels,” they added. “Stressed and illiquid markets may lead to an increase in the execution risk adjustment, which can cause larger pricing deviations from bid-side NAVs, as ETF prices tend to more fully reflect market risk premia and true execution costs.”
In other words, market makers in ETFs tracking illiquid bonds aren’t relying on a “stale” NAV in volatile markets. The market makers are trying to value bonds that may not have traded for days. When determining their own risks and the appropriate ETF bid-ask spreads, the market makers are attempting to estimate what the bonds would be worth if immediately sold in the open market.
“In normal markets, there is little difference between where bonds trade individually and where they trade as a basket,” according to BlackRock. “In markets of extreme volatility, however, significant differences can arise. What drives these price differences is that the underlying portfolio value is not an actionable value, while the price of the ETF is actionable.”
BlackRock’s Tucker in a Bloomberg story published Sunday said the recent discount to NAV observed in iShares iBoxx High Yield Corporate Bond ETF (NYSEArca: HYG) reflected the price where investors can exchange risk.
“It’s the correct price. The reality is the majority of the high-yield market doesn’t trade every day,” Tucker said in the report.
“People are using ETFs to trade risk when investors need to access the markets and adjust positions, and need to do so in a quick market,” he said. “They’re being more widely used by more investors as a liquidity tool in stressed markets.”
Brendan Conway examined this phenomenon in a Barron’s weekend story.
“Particularly in less-liquid areas such as municipal and high-yield bonds, the ETF becomes a kind of trailblazer for the price discovery of the entire market, leading prices wherever they’re headed, and becoming more volatile in the process. It’s in those moments of stress that investors have to be especially cautious with their exit buttons,” he wrote.
“Stepping back from the industry mechanics, it’s enough for investors to know they should learn how an easily tradable fund behaves if it’s built atop a less-than-ideally liquid underlying market. Specifically, investors have to be comfortable knowing that they’re in the hot seat: They own the instrument that’s right at the edge of price discovery,” he added. “Liquidity is a good thing, and one of the virtues of ETFs versus mutual funds is that they effectively force today’s traders to pay their own way. But just because you can trade doesn’t mean you should.”
Full disclosure: Tom Lydon’s clients own HYG.