Fire Sale: Bond ETFs Trading Like Closed-End Funds

Almost anywhere you look, bond exchange-traded funds are trading at fire-sale prices.

Dislocations in credit markets are reaking havoc with the delicate balance between ETFs' net asset values and their underlying bond prices. In some cases, the distorations are shattering historic levels.

"Some participants in the market right now might be questioning the NAVs on their bond ETFs," said Alan Brochstein, an independent buy-side analyst who consults for institutional investors. "It's a very unusual situation caused by the enormous disruption we're seeing in credit markets around the world."

For example, consider the $9.3 billion iShares Lehman Aggregate Bond Index Fund (NYSEArca: AGG). The so-called 'total market' style ETF, which includes corporates along with Treasuries, wound up selling at a 3.4% discount on Thursday. A day later after markets capitulated, AGG finished the week with an even steeper discount of 8.85%.

That broke its previous record by more than 20%, according to Barclays Global Investors.

A review of all bond ETFs currently listed in IndexUniverse's database found that even bigger discounts are showing up in other areas of fixed income. In fact, some bond ETFs are now trading at premiums. (See chart below).

"This is something new to the industry and different from what we've seen in the past," said Roger Nusbaum, portfolio manager at Phoenix, Ariz.-based Your Source Financial.

The high-yield category has been particularly rocked. The iShares iBoxx High Yield Corporate Bond Fund (AMEX: HYG) was selling at a discount of 27.99% entering trading on Tuesday. And the PowerShares High Yield ETF (AMEX: PHB) had a discount of 15.44%.

Consider that HYG's greatest discount up to this point has been 7.94%. Meanwhile, PHB had never traded at a significant discount, according to historical data provided by PowerShares.

In an interview last week, Barclays Global Investors' Matthew Tucker pointed out that while bid/ask spreads are being impacted in bond ETFs, such price dislocations for individual issues are in many cases even bigger than with ETFs.

The head of fixed income for the iShares product line also noted that such was the case particularly with less-liquid areas of the bond market, especially high-yield funds. (See story here).

Investment-grade corporate ETFs are feeling the impact as well. The iShares iBoxx Investment Grade Corporate Bond Fund (AMEX: LQD) was discounted at more than 6% entering Tuesday. Also, a broad index-based ETF with heavy exposure to corporates, the Vanguard Total Bond Market (NYSE: BND)—which competes most directly against AGG—had a discount of nearly 2.5%.

International bonds were also feeling the impact of shifting credit markets. The SPDR Lehman International Treasury ETF (AMEX: BWX), which only invests in high-grade issues overseas, was trading at a 5.64% discount. And PowerShares Emerging Markets (AMEX: PCY) was discounted some 8.45%.

Interestingly, the municipal bond market was going in the other direction. The PowerShares Insured National Muni (AMEX: PZA) was actually trading with a premium of 3.18%. But state-specific issues were fetching even greater premiums: the SPDR Lehman California Muni (AMEX: CXA) at 4.82% and the PowerShares Insured California Muni (AMEX: PWZ) at 9.73%. Meanwhile, the PowerShares Insured New York Muni (AMEX: PZT) came in at 4.81%.

"It's not surprising what's going on in the market," said analyst Brochstein, owner of AB Analytical Services in Houston.

"There's so much demand for cash like now. People are selling en masse. The market conditions are making it very difficult for the arbitrageur to keep prices in line with NAVs," he added.

A good example is AGG, which is averaging around 600,000 shares traded per day. "That's not a really huge volume level, which indicates to me that this is being held by a lot of managers and advisors as core positions," Brochstein said. "That means a lot of people are trying to go to cash, which is just the opposite of what asset allocation is all about - they should be buying now with markets going down."

Those are investment vehicles that trade existing shares on exchanges. But after an initial public offering, closed-end funds typically don't offer new shares anymore. That causes dislocations in underlying values on a regular basis. In those types of funds, investors are often told by advisors to look for portfolios selling at discounts of 5% or more.

By the same token, the rule of thumb is to not buy funds trading at a surplus—for obvious reasons.

"Clearly, there are distortions around the entire fixed-income market. A by-product is that some ETFs are trading at discounts. But in terms of looking out six months from now, there are clearly opportunities," said portfolio manager Nusbaum.

"If you're able to stomach being wrong by something like 10% in the short term, then there are clearly trading opportunities," he added.

One aspect that goes hand in hand with market panics, says Nusbaum, is that people realize their tolerance for volatility is less than they thought. "So looking out a few years, anything you buy at this point is probably going to be at very good price levels," he said.

But in his firm's client portfolios, Nusbaum isn't willing to treat ETFs like closed-end funds at the moment.

"At this point, I won't speculate with long-term money on buying an ETF at a discount," he said.

Although that could take weeks rather than months or years to sort out, market observers note that what's going on in credit markets reflects a unique set of circumstances.

"What we're seeing take place now with bond ETFs is new to the industry," Nusbaum said. "On occasion in the past, we've had small little deviations between prices and NAVs take place. So eventually, the mechanisms built into the market that've worked before to keep everything aligned should eventually kick in."