Bond ETF discounts during recent volatility

18 March 2020 | Markets and Economy


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Commentary by Rich Powers, Vanguard head of ETF product management

The waves of volatility from the coronavirus outbreak have reached every corner of the financial markets. For bond ETFs, the waves have resulted in both volatile market price swings and larger-than-usual gaps between market prices and net asset values (NAVs). While such gaps can be unsettling, history shows that premiums or discounts are always present with bond ETFs, and their widening amid market volatility tends to be short-lived.

Bond ETFs are an important source of liquidity

Along with heightened market volatility in the bond market over the last week, there's been a drop in liquidity of many types of individual bonds—that is, the willingness of market participants to buy and sell. Bond ETFs, on the other hand, have maintained their liquidity and have been the primary mechanism for price discovery in the fixed income markets.

In such a volatile environment, bond ETFs can be expected to trade at discounts or premiums. Though discounts and premiums of this breadth and magnitude are rare, bond ETFs have been tested during prior bouts of volatility and actually do a good job of reflecting in real time the value of the underlying fixed income securities. In times of volatility with rapidly evolving macroeconomic, interest rate and credit environments, investors should expect premiums or discounts in bond ETFs. Bond ETFs tracking similar benchmarks have experienced large variations in market returns as well.

Fewer inputs can create greater price disparities

Discounts and performance differences reflect the fact that there are two ways to determine portfolio values. In setting end-of-day NAVs, ETF pricing specialists use both actual trades and an adjustment factor based on bid/ask spreads for bonds, especially for bonds that haven't traded recently. Market prices, in contrast, are collectively determined by ETF investors and “market makers”. If, as happened in the last week, bond trading is fairly diminished in the underlying market, NAV calculations will have fewer inputs and thus there's an increased chance for differences from market prices.

Unlike a NAV that's calculated by a pricing provider, market prices for bond ETFs reflect the market's minute-by-minute judgment, which includes factors such as: 

  • Valuation estimates of the underlying holdings by market makers.
  • Supply and demand for the ETFs.
  • The cost for providing liquidity in fast-moving markets where underlying bonds may have less liquidity.

Since these calculations have different inputs, investors should expect different outcomes, particularly in volatile markets. When viewed over longer periods—say a month or a quarter—these short-term disparities are generally imperceptible, as they are over a “normal” day or week.  

Historically, bond ETF premiums and discounts have been tiny

One case in point: More than 3,200 days of trading using a broad market fixed income ETF for illustrative purposes.

Past performance is not a reliable indicator of future results.

Notes: The chart depicts the frequency of premiums and discounts of various sizes between the market price and the net asset value of an actual Vanguard broad market fixed income ETF, which is registered in the US and for illustrative purposes only. Data is recorded between the fund's inception on 3 April, 2007, and 16 March, 2020. Premiums and discounts are based on end-of-day market prices and NAVs. On 2,940 of 3,263 trading days—90% of the time—the market price ranged between a discount of 0.2% and a premium of 0.4%. There were discounts of more than 0.2% on just 15 days.  The fund used for illustrative purposes is not registered for sale in Europe.

Source: Vanguard.

ETFs as shock absorbers

Bond ETFs serve as a vital source of price discovery and as “shock absorbers” for liquidity during relatively illiquid periods. About 80% of trading in fixed income ETFs typically takes place on the secondary market—that is, involve investors trading ETF shares among themselves—and do not prompt any trading in the underlying securities. Recently, Vanguard bond ETF trading volume has been triple the normal level, meaning bond ETFs have really been a go-to source of liquidity for all types of bond investors.

When comparing an ETF's market-price return with its return based on its NAV, focusing on a single day or week as a relevant snapshot of performance may be misleading. It's also worth remembering that, because outperforming the market is a zero-sum game, not all investors are selling at (or into) the discounts. In fact, investors on the other side of recent trades have been buying at a relative discount.

Amid periods of remarkable market volatility, and given the rapidly evolving macro, interest-rate and credit environment, we remind ETF investors that increased divergence between a fixed income ETF's market price and its NAV is to be expected.



Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Other important information:

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients).  In Switzerland, for professional investors only.  In Switzerland, for professional investors only.  Not to be distributed to the public.

This document is published by Vanguard Group Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments. It should be noted that it is written in the context of the US market and contains data and analysis specific to the US.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

The funds may invest in financial derivative instruments that could increase or reduce exposure to underlying assets and result in greater fluctuations of the fund's Net Asset Value. Some derivatives give rise to increased potential for loss where the fund's counterparty defaults in meeting its payment obligations.

Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority. In Switzerland, issued by Vanguard Investments Switzerland GmbH.

© 2020 Vanguard Asset Management, Limited. All rights reserved.

© 2020 Vanguard Investments Switzerland GmbH. All rights reserved.


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