Last Updated: 4 December 2023
There’s been a lot of talk recently about the fact that bond ETFs can trade to large discounts during periods of market distress. The reporting has been histrionic, insinuating that ETFs are not a good vehicle for gaining bond exposure. The implication is that mutual funds are a better choice.
The irony of these arguments is that, by their own logic, they suggest that bond mutual funds actually have bigger problems than bond ETFs.
The truth is, neither vehicle is perfect.
Bond markets are illiquid, and investing in illiquid markets has a cost—if you want to sell something illiquid during periods of market distress, you’re going to get less than you’d like. What’s important to realize that the way you pay-the-piper for buying illiquid assets is different depending on whether you invest in a mutual fund or an ETF.
How Bond Products (ETFs and Mutual Funds) Calculate Net Asset Value
The first step in understanding the issue here is to understand how net asset values (NAVs) are calculated (for both ETFs and mutual funds).
The place to start is with equity investments. For equity mutual funds or equity ETFs, NAV calculations are simple. Take an ETF that holds all 500 stocks in the S&P 500 Index. To calculate the NAV, all you have to do (essentially) is look at the closing price for all the stocks in the S&P 500 and you’re done.
For bond ETFs – and particularly for bond ETFs tracking illiquid corners of the fixed income market like municipal bonds – it’s trickier. There is no official exchange for municipal bonds, and no consolidated tape, so there is no one agreed upon price for what the value of any particular bond may be. Many muni bonds don’t even trade on a daily basis: they may go days, weeks, or months between trades.
To calculate the NAV for a fund like the iShares National AMT-Free Muni Bond ETF (MUB), iShares relies primarily on bond pricing services. These prices are “provided directly from one or more broker-dealers, market makers, or independent third-party pricing services which may use matrix pricing and valuation models to derive values.”
In other words, it is the job of the bond pricing services to guess what a given bond is worth at the end of each day. They base those guesses on reported trades, surveys of bond trading desks, instant messenger chatter, or derivative pricing models that reference other areas of the market to estimate the value of individual bonds. But they’re still just guesses.
How and Why Bond ETFs Trade To A Discount
The issue that’s come up repeatedly — and which the media has reported on repeatedly — is that, during periods of market stress, bond ETFs tend to trade at large discounts to their stated NAVs. On June 21, for instance, MUB closed at a 2.73 percent discount to its stated NAV.
Why does this happen? Let’s take a simplified example and see.
Imagine that you have a municipal bond ETF whose entire portfolio is composed of one bond. On any given day, the net asset value (NAV) of the ETF is equal to the price of that bond.
Most of the time, the price of the ETF will be very close to the NAV. But let’s imagine that, during a period of market stress (like the one that happened on June 21), a disconnect occurs: The ETF closes the day at $95 but its reported NAV is $100.
The ETF industry argues that the NAV here is “wrong,” and that the bond pricing services are overestimating the true clearing price of the underlying bonds. Their argument is built on the principle of arbitrage.