Are Bond ETFs Passing the Test Right Now?

We’re all aware of what’s happening with stocks right now, but there's also some concern with exchange traded funds (ETFs) that hold a broad portfolio of bonds based on a benchmark or index.

Recently, shares of these ETFs have started trading at discounts to the total value of their assets. In typical market conditions, the price you pay per share nearly matches the value of the underlying assets — $1 per share gets you $1 of assets. However, market conditions have been historically volatile lately, and it’s creating a rift between bond ETF prices and their underlying bonds.

Using Morningstar data through Mar. 20, we found that the average fixed-income ETF on our Research List trades at a price 2.36 percent below the value of its underlying assets, and we’re even seeing a few funds with discounts greater than 4 percent. Lately, it would appear $1 paid for every share of a bond ETF gets you, hypothetically, $1.02 or $1.04 in assets. But in normal market environments, there wouldn’t be much discount at all.

This discrepancy between asset value and share price in bond ETFs has lead some people to doubt the viability of bond ETFs, even questioning whether bonds are suitable investments under an ETF structure. That’s because, on the surface, it would appear bond ETFs are underperforming their own benchmarks.

While we’ve had similar concerns in the past, we don’t think the fixed-income ETF model is broken. We don't think ETFs are underperforming their benchmarks, either. In fact, we think these funds are providing valuable information and liquidity for markets right now.

HOW CAN BOND ETF SHARE PRICES DIVERGE FROM THEIR BENCHMARK?

In general, discounts stem from a liquidity mismatch between ETFs and their underlying bonds. Fixed-income ETFs trade like stocks, and investors can trade them continuously throughout the day on centralized exchanges. When you go to sell a bond ETF, there’s typically an ample supply of buyers.

However, the actual bonds that comprise an ETF’s holdings don’t trade as frequently or as easily. There’s not always a buyer on the other side when you want to sell an individual bond. Some bonds aren’t traded every day. Sometimes, there might be a buyer, but they’re asking a far different price than you offered.

VOLATILITY IS EXPOSING DIFFERENCES IN BOND AND ETF MARKETS

In today’s incredibly volatile market, we are seeing the rift between bond market behavior and ETF market behavior grow. Bond ETF trading volumes, for example, have spiked in recent weeks. However, activity (i.e. liquidity) in many parts of the underlying bond markets has dried up. Shares of LQD, an ETF holding investment-grade corporate bonds, changed hands approximately 90,000 times in a recent trading session. The top 5 underlying bond holdings in that same ETF, by comparison, traded an average of just 37 times over the same timeframe.

When index providers value a fund’s net asset value (or NAV), they typically use a third-party pricing service. But the pricing models those services use to assess the value of bonds (known as fair value) don’t reflect actual trades of those bonds in the market — at least right now.

What we’ve seen over the past few weeks, according to market-makers and ETF sponsors, is that fund NAVs represent stale information and don’t accurately reflect market prices. Fair value estimates are one thing, but the actual price someone will pay can be completely different during periods of market volatility.

While it may look like a bond ETF is underperforming its own benchmark, the share price is likely reflecting the real market value of its underlying assets, not the benchmark pricing model’s. Therefore, bond ETFs aren’t necessarily undervalued, or underperforming. The NAV price simply hasn’t caught up to the ETF share price.

HERE’S THE BOTTOM LINE ON BOND ETFS

Bond ETFs, and ETFs in general, provide a valuable function in markets. They offer investors easy access to diversified baskets of assets and investing strategies. They also provide liquidity and price discovery, even when a fund’s underlying investments are traded in markets with limited to no trading. We’ve seen that with bond ETFs in recent weeks. But we also see it every day when international equity ETFs trade in the U.S. while foreign markets are closed. ETFs provide insight into where buyers and sellers are willing to transact given the current market environment.

We expect that over the long term, ETF prices will once again closely align with their benchmarks. It’s only during periods of heightened volatility that these values differ so widely. We saw a similar scenario in 2008, only to see bond ETF prices converge with their benchmarks and maintain a stable relationship, at least up until the past few weeks. Even during this transitory divergence, fixed-income investments remain a ballast for stability in a long-term portfolio.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss in a down market.

Exchange traded funds (ETFs) have risks and trade similar to stocks. Shares of ETFs are bought and sold in the market at a market price, as a result, they may trade at a premium or discount to the fund's actual net asset value. Investors selling ETF shares in the market may lose money including the original amount invested.

You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States are at, or near historic lows, which may increase a Fund’s exposure to risks associated with rising rates.