The scarce liquidity in the bond market showed up in Vanguard’s flagship $50bn Total Bond Market ETF (BND), one of the world’s largest ETFs, which was trading at a 6.2% discount to its net asset value (NAV) last week.
The discount, which is a price below an ETF’s fair value, came at the close of trading on 12 March as coronavirus fears swept through global markets. BND is currently trading at a 1.93% discount.
Discounts, which are common on other types of vehicles such as close-ended investment trusts, occur when a reduction in liquidity and increased volatility creates a scenario where market makers do not have a clear idea of how to price risk.
Because there is uncertainty around the fair value of the underlying bonds, trading becomes more expensive as a situation can be created where hedging risks and costs become more expensive than the arbitrage between the ETF and the underlying securities.
Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, said fixed income ETFs are better at pricing their underlying securities than NAV because they are traded in real time.
“NAVs for some bonds likely lag well behind during periods of market stress, leading to discounts that create a clear arbitrage opportunity for market makers to step in and profit,” Psarofagis explained.
“The persistence of such discounts indicates to us that the gaps are only theoretical, since market makers have hesitated to close them.”
However, discounts can still frustrate investors, who purchase ETFs with the presumption they will track the underlying index.
A number of fixed income ETFs have traded at discounts amid the increase in volatility over the past two weeks including the $3.8bn VanEck Vectors High-Yield Municipal Index ETF(HYD) which traded at a 5% discount.
