I also covered P/Ds in bond ETFs in an earlier two-part blog. In part 1, I introduced how P/Ds are largely a function of the respective pricing mechanisms for individual bonds and ETFs. In part 2, I explained how the level and variability of P/Ds can be affected by the trading flow in the market and the liquidity of the underlying bonds, concluding that “the greater the relative pressure to sell an ETF, the lower the level of the bid-ask quote and thus the lower midpoint of that quote. In that case you would see the premium fall or maybe even witness a discount.”
Now, bond ETF P/Ds can be somewhat misleading because transaction costs are more transparent with ETFs than with traditional mutual funds. In times of heavier order flow or less liquidity, the bid-ask spreads of underlying securities could widen to reflect the current market situation, leading to greater P/Ds for bond ETFs. A mutual fund portfolio manager trying to buy or sell the same basket of bonds may also be paying the same bid-ask spread. However, investors do not see those costs in real time; they end up manifesting themselves after the fact as part of the fund’s NAV. [Bond ETF Liquidity Risks: Facts vs. Fiction]
To put a fine point on it: P/Ds in bond ETFs are largely a reflection of the externalization of investors’ transaction costs.
The appearance of P/Ds among international stock and bond ETFs is a natural outcome of the relationship between the ETF and its underlying securities: There are times when market conditions result in higher transaction costs or larger deviations between current and stale security pricing.
Jim Rowley, CFA, is a senior investment analyst in Vanguard Investment Strategy Group, where he analyzes trends and developments in the ETF market and provides research and commentary on related issues.