One of the primary reasons investors embrace municipal bonds and the related ETFs is the asset class’s reputation for low volatility. Even the VanEck Vectors High-Yield Municipal ETF (CBOE: HYD), which focuses on lower-rated municipals, usually isn’t an ETF for adrenaline seekers.
However, in this months topsy turvy market, that normally docile reputation has gone out the window as scores of fixed income ETFs have tumbled to substantial discounts to their net asset values (NAV). Like other bond ETFs, HYD has been beset by widening spreads and dwindling liquidity in the underlying assets the fund holds.
“Looking back at the history of HYD, the phenomenon that we are experiencing now, as it relates to heightened or pronounced discounts, has been seen before, albeit much more exacerbated this time around,” said VanEck ETF Capital Markets Director James Kim in a recent note. “But the root cause remains the same: wider spreads and reduced liquidity of the underlying, which is being conveyed through the secondary market price of the ETF and creating the discount that I am sure everyone has noticed.”
Last week, HYD fell 13.09%, a stunning weekly move for any muni bond ETF, and one punctuated by 3.31% gain last Friday on more than triple the average daily volume. HYD entered Friday at 20% discount to NAV, according to VanEck data, and that was down from almost 28% the prior day.
Those are extraordinary percentages because, over HYD’s more than 11-year life-span, the fund typically trades at barely noticeable premiums to NAV. The NAV discounts experienced by the fund last week were the widest since late 2016.
Not all bonds trade every day but many bond ETFs do vibrant daily markets and, in the case of HYD, it’s one of the most heavily trade high-yield muni funds out there. However, third-party data providers need to price bonds – even the ones not trading – every day.
“NAV uses matrix pricing, which is done by a third-party data provider and involves assessing trades, the dealer runs, quotes, etc. to come up with a price that they think a particular bond is worth on any particular given day,” said VanEck’s Kim. “Because everything trades over the counter in fixed income and because, on any given day, a particular bond—and in this case a high yield muni bond—may not even trade, it’s no easy task for this third-party provider to come up with a valuation of the bond. NAVs are calculated off the back of that.”
“There has been no limitations on redemptions. Everything has been almost status quo from our standpoint. I think it is important to keep in mind that market prices for ETFs are a price discovery process,” said Kim. “Regardless of the magnitude of discount that we are seeing, we believe that a secondary market price is the true price of liquidity at this point, given what is going on in the secondary market.”
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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.