With historic levels of volatility plaguing markets throughout this month, bond ETFs seem to be undergoing mismatches in ETF prices, creating in some cases large gaps between the prices that fixed-income ETFs trade at and the net asset value of the fund. 

One example of such a gap has happened with the Vanguard Total Bond Market ETF (BND), which closed at a 6.2 percent discount on March 12. A similar phenomenon was seen in the iShares Core US Aggregate Bond ETF (AGG), which closed at a 4.43 percent discount on the same day.

Large discounts have also appeared for the largest ETF tracking the US investment-grade corporate bond sector, BlackRock’s LQD. 

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is not just the largest investment-grade corporate bond ETF. It is one of the largest fixed income ETFs of any variety. Over its more than 16 years on the market, LQD has played an increasingly important role in helping investors of all stripes gain cost-effective, liquid exposure to a broad basket of high-grade corporate debt.

“All the big fixed-income ETFs have started trading at surprisingly large discounts to their net asset values. This is not supposed to happen. This disconnect shows that something has gone awry,” says Duncan Lamont, head of research and analytics at Schroders.  

The market makers and large institutions typically take on the role of regulating between the price of the ETF and its underlying index to maintain this gap stays as small as possible. 

Therefore, if a price gap occurs, market makers are supposed to buy the ETF while at the same time selling the basket of underlying bonds, oftentimes operating with very limited capital, with the capacity to buy and sell the majority of bonds in the market in order to facilitate the development and redemption of ETF units.

However, with the CBOE VIX spiking to historic levels of 85+, the jump in the volatility of bond prices has compelled market makers to raise the price spread at which they are willing to purchase and sell ETFs in order to protect themselves.

“The root of this problem lies in the fact that liquidity in corporate bond markets has deteriorated considerably compared with the pre-financial crisis years. It is a lot harder to buy and sell corporate bonds than it used to be,” says Mr. Lamont.  

Now, however, some critics feel that the pricing disconnections are a warning sign that more serious problems could arise in the future. “The risk of a liquidity event where investors decide to sell the ETFs because they no longer represent the underlying bonds is rising,” says Peter Chatwell, head of Multi-Asset Strategy at Mizuho.  

If investors start to doubt the functioning of ETFs, this will “generate much more selling, causing a downward spiral in liquidity and dislocating bonds from their fundamental level,” warns Mr Chatwell. 

For more market trends, visit  ETF Trends.