As Arbitrage Falters, Bond ETFs Teeter

Exchange-traded funds can be attractive alternatives to mutual funds and closed-end funds in important ways when market mechanisms work as intended.

However, bond ETF mechanics for several bond categories have broken down, making no-load and low-expense bond mutual funds currently more attractive than their ETF cousins.

No-load mutual funds work at net asset value, but ETFs with broken arbitrage mechanisms can trade at substantial discounts and premiums to NAV, much like closed-end funds.

ETFs were designed to solve the premium/discount problem of closed-end funds, and to provide intraday liquidity and shorting potential that is lacking with mutual funds.

It's a great idea when it works, but risk aware investors need to observe the premium/discount on ETFs to make sure the arbitrage mechanism that minimizes premiums and discounts is functioning.

Arbitrage is clearly not functioning properly for some bond types in this current difficult credit market. As a result, it might be better sticking with no-load and low-expense index mutual funds for those bond categories with broken ETF arbitrage.

Consider this table of ETF premiums and discounts for several bond index categories:

The above table shows the premium or discount history for Q3 2008 and for December 11, 2008. Green shading indicates expected premium/discount behavior. Yellow shading indicates unexpected, but perhaps tolerable behavior. Pink shading indicates unacceptable premium/discount behavior.

If the expected premium/discount of +/- 0.5% occurred for 90% or more of the days, the fund is shaded green. If the expected range occurred for 80% to 90% of the days, the fund is shaded yellow. The fund is shaded pink if the expected premium/discount range occurred for less than 80% of the days.

Only sovereign U.S. Treasuries, mortgage-backed securities (agency debt) and the aggregate bond (with lots of Treasury and guaranteed agency debt in it), earned green shading. Municipal bonds and non-U.S. investment-grade Treasuries earned a cautious yellow shading. Liquid-investment grade corporates, high-yield corporates and emerging market sovereign Treasuries pretty much fell off a cliff in terms of percentage of days within expected boundaries (44%, 11% and 3%, respectively).

We assigned a green shade to premiums or discounts that were within the expected +/- 0.5% range, a yellow if over 0.5% up to and including a 1% deviation from NAV and a pink for a premium or discount greater than 1%.

All of the Treasury funds earned a green or yellow shade in all periods except for TIPS, which crept over the line to pink as of Dec. 11 with a 1.07% premium.

The investment-grade agency mortgage-backed securities ETF did surprisingly well with green and yellow. It includes agency debts that were not federally guaranteed at the beginning of the period, but were federally guaranteed by mid-period.

The municipal bond ETF had adverse conditions mostly to the premium side, ending Dec. 11 with a 3.59% premium. Interestingly, municipalities are in financial stress, California is running out of cash and MUB is trading at a premium. We'd rather buy munis at NAV in a mutual fund.

The aggregate bond ETF went for a roller-coaster ride ranging from a premium of 1.59% to a discount of 8.67%, but is within the expected green shaded range now.

Similarly, non-U.S. investment-grade Treasuries bounced around to plus and minus premiums, but are now at a 4.17% premium.

Liquid investment-grade corporates, high-yield corporates and emerging market Treasuries have been out of whack, including deep discounts of 11.34%, 7.95% and 4.21%, respectively. They are still out of whack, although emerging market Treasuries are approaching the tolerable yellow zone.

If you want to play with risk premiums and discounts, these bond ETFs may be for you (e.g., AGG from 8.66% discount to 1.60% premium, and LQD from 11.34% discount to 2.80% premium). However, if you are a bond investor looking to be at or near NAV and you aren't looking for Treasuries, you need to be in no-load, low-expense mutual funds.

Here is a list of low-cost Vanguard funds that come reasonably close to approximating the same opportunity and risk as the indexes that the bond ETFs track. They have the additional appeal of not risking your investment going to premium or discount levels like closed-end funds. Most are index-based, except in categories where such an option isn't offered by the fund company. (The list also includes two relatively low-cost T. Rowe Price foreign bond funds since there aren't any Vanguard mutual fund alternatives.)

Because at least some of them are superficially obviously not "substantially identical" to the bond ETFs, and also because of the broken arbitrage, they may also be useful as asset allocation substitutes in a tax loss harvesting and rebalancing effort that would be compliant with the IRS Wash Sale Rule (ask your tax advisor first).

The indices they track are not exactly the same. Vanguard offers three maturity ranges based on Lehman indices (recently renamed Barclays indices after Lehman was purchased by Barclays), whereas Barclays offers five maturity ranges based on Lehman/Barclays Treasury indices.

The Vanguard 1-5 year U.S. Treasury fund overlaps the Barclays 1-3 year fund and the 3-7 year fund. The Vanguard 5-10 year U.S. Treasury fund overlaps both the Barclays 3-7 year fund and the Barclays 7-10 year fund. The Vanguard "long" Treasury fund overlaps the Barclays 10-20 year fund and the Barclays 20+ year Treasury fund.

The Barclay's mortgage-backed securities fund was not formerly a good match to the Vanguard GNMA fund, but now that the U.S. government has expressly guaranteed FNMA and other agency debt of the type found in the mortgage-backed Barclays fund, the credit risk of the two funds is virtually the same.

The Vanguard funds are available in two series with different expense ratios based on the size of the investment (minimum $100,000 for the lower expense ratio).

Price charts below plot the bond ETF and the no-load mutual fund alternative together. The left scale is for the mutual fund, and the right scale is for the ETF.

MBB and its alternate fund show huge differences until recently when they began to move together. That appears to be caused by the fact that before the bailout, the alternate GNMA fund was government guaranteed, while the mortgage backed ETF had agency debt that was not federally guaranteed. Now that debt of GNMA, FNMA, FREDDIE and other key mortgage agencies are all federally guaranteed, the funds should, and apparently do, serve as reasonable substitutes for each other.

If you see opportunity in trading around premiums and discounts, bond ETFs with broken arbitrage could be for you.

If you seek bond investments that you can enter and exit at NAV, you should give no-load, low-expense index mutual funds consideration—at least until the credit crisis is well behind us.