Understanding Bond ETF Discounts

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Understanding Bond ETF Discounts

Post by Rick Ferri » Sat Mar 21, 2020 6:41 am

Bond ETFs have been trading at discounts to net asset value (NAV) in the past few weeks, On Monday, March 16, the iShares Core U.S. Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND) traded at discounts of 4.43% and 6.17%, respectively. Over the past year, AGG and BND usually trade at average premiums to NAV less than 0.10%.

To understand better what's going on, ETF.com asked market maker Reggie Browne. I've known Reggie for several years. He is probably the most knowledgeable person alive on ETF trading. He has been making markets for ETFs since their inception.

Here is the article:

Why Many Bond ETFs Now Trading At Discounts

Here are some highlights:

"When fixed income ETFs trade at a 4% or 5% discount, it's because you're seeing stale prices in the underlying bonds, where the marketplace has fair valued them. The ETFs are giving real-time price action, where the bonds are actually trading."

"...only 20% of corporate bonds trade every day. But fair value agents, like IDC [Interactive Data Corporation], must come up with a fair value of the portfolio of corporate bonds [to create a daily NAV]. If those bonds don't trade every day, they still take a fair value, and a lot of times the prices are stale. [the computer is using old data]"

"...the bond market structure isn't doing a good job of reflecting in real-time where bonds are trading. ETFs are doing it for them."

----

In a nutshell, ETF are pricing bonds correctly. It's the NAV is wrong. So, if you bought Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) on March 16 at the NAV price, you overpaid by about 6%. If you bought Vanguard Total Bond Market ETF (BND), you bought at fair market value. Vice versa, if you sold VBTLX on March 16, you earned an extra 6% more than the market value of the bonds in the fund, and if you sold BND, you got the correct market price.

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Re: Understanding Bond ETF Discounts

Post by JohnDoh » Sat Mar 21, 2020 6:53 am

Excellent article. Thanks for sharing.

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Re: Understanding Bond ETF Discounts

Post by Bylo Selhi » Sat Mar 21, 2020 7:21 am

Thanks Rick. Vanguard provides a 90 second explanation on YouTube Bond ETF discounts: What they are and why they happen ["AP" means authorized participant]

P.S. There are several other short videos on Vanguard's YouTube channel that relate to the current market.

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Re: Understanding Bond ETF Discounts

Post by bgf » Sat Mar 21, 2020 7:29 am

Rick, i saw your tweet on this and jumped here to see if there was a thread.

so, all the data analysts look at for bonds and bond funds over the decades is "incomplete" if based on NAV? much of those NAV numbers are just 'guesses' at values for stale bonds that didnt trade during market panics.

since ETFs, we now have a far more accurate picture of how bonds trade during market panics, even when there are stale prices for individual bonds within the ETF.

how should the data be interpreted to reflect this?
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Re: Understanding Bond ETF Discounts

Post by acegolfer » Sat Mar 21, 2020 7:30 am

It's time to rebalance from VBTLX to VTSAX.

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Re: Understanding Bond ETF Discounts

Post by nisiprius » Sat Mar 21, 2020 8:13 am

Regardless of which is "correct," the NAV or the ETF market price, it is still true that the mutual fund is required to redeem at NAV.

If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.

And that means that, just as with bid-asked spread, the comparison between ETFs and mutual funds is tricky. Doctrinaire statements that ETFs are simply better in every way, with the implication that the ETF investor is always going to end up with a few more dollars in their pocket--due to lower costs and better tax efficiency--are wrong.

ETF discounts, in this case in the 5% ballpark, are, I think, practically unheard of, and so are just a featherweight on the scales, but they are on the mutual fund side of the scale. The collapse of the Third Avenue Focused Credit fund, a featherweight on the ETF side, but just a featherweight. The flash crash, a featherweight on the mutual fund side, but just a featherweight. And so on and so on.
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Re: Understanding Bond ETF Discounts

Post by Rick Ferri » Sat Mar 21, 2020 8:13 am

bgf wrote:
Sat Mar 21, 2020 7:29 am
Rick, i saw your tweet on this and jumped here to see if there was a thread.

so, all the data analysts look at for bonds and bond funds over the decades is "incomplete" if based on NAV? much of those NAV numbers are just 'guesses' at values for stale bonds that didnt trade during market panics.

since ETFs, we now have a far more accurate picture of how bonds trade during market panics, even when there are stale prices for individual bonds within the ETF.

how should the data be interpreted to reflect this?
The Vanguard video posted above does a good job of explaining what is happening. There is a market for bonds that's made by dealers - it's their job. But the dealers don't know what price they can sell the bonds for because no one is buying. So, they're forced to take on new inventory without knowing when they'll be able to sell bonds for or when. That causes them to mark down their buy price, which is the cost of you pay for selling right now. That's how ETFs trade.

If you want to step in and provide liquidity by buying bond ETFs now and holding them, then you're getting a good price. BTW, the same thing is happening in the stock market. If you're willing to buy now and hold, you're getting a good price in the long-term.
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Re: Understanding Bond ETF Discounts

Post by nisiprius » Sat Mar 21, 2020 8:19 am

bgf wrote:
Sat Mar 21, 2020 7:29 am
how should the data be interpreted to reflect this?
In my unasked-for opinion, we should interpret it this way.

Source

Last ten years:
Image

Last thirty days:
Image

If the orange line is the truth and the blue line is a lie, so be it. The amount of worry I have is equal to the amount of air I can see between the blue and orange lines on each chart.
Last edited by nisiprius on Sat Mar 21, 2020 8:21 am, edited 1 time in total.
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Re: Understanding Bond ETF Discounts

Post by vineviz » Sat Mar 21, 2020 8:21 am

nisiprius wrote:
Sat Mar 21, 2020 8:13 am
Regardless of which is "correct," the NAV or the ETF market price, it is still true that the mutual fund is required to redeem at NAV.

If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.

And that means that, just as with bid-asked spread, the comparison between ETFs and mutual funds is tricky. Doctrinaire statements that ETFs are simply better in every way, with the implication that the ETF investor is always going to end up with a few more dollars in their pocket--due to lower costs and better tax efficiency--are wrong.

ETF discounts, in this case in the 5% ballpark, are, I think, practically unheard of, and so are just a featherweight on the scales, but they are on the mutual fund side of the scale. The collapse of the Third Avenue Focused Credit fund, a featherweight on the ETF side, but just a featherweight. The flash crash, a featherweight on the mutual fund side, but just a featherweight. And so on and so on.
The full story is pay-walled, unfortunately, but Bloomberg Law reported yesterday on bond mutual funds in Sweden:

At least 30 bond funds in Sweden have suspended trading meaning that investors can no longer withdraw their cash.
https://news.bloomberglaw.com/securitie ... emptions-1

Another featherweight, for sure, but this one on the side of ETFs.
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Re: Understanding Bond ETF Discounts

Post by zwzhang » Sat Mar 21, 2020 8:24 am

I have been searching for an explanation in last few days. Thank you! Rick.

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Re: Understanding Bond ETF Discounts

Post by nisiprius » Sat Mar 21, 2020 8:26 am

vineviz wrote:
Sat Mar 21, 2020 8:21 am
...The full story is pay-walled, unfortunately, but Bloomberg Law reported yesterday on bond mutual funds in Sweden:
At least 30 bond funds in Sweden have suspended trading meaning that investors can no longer withdraw their cash.
https://news.bloomberglaw.com/securitie ... emptions-1

Another featherweight, for sure, but this one on the side of ETFs.
Indeed. Thanks. Interesting.

Let's both try to remember to follow this and see how long it lasts and how much money they lose by being denied the opportunity to sell. A minor inconvenience, a major nuisance, or a Third Avenue Focused Credit-like disaster?
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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sat Mar 21, 2020 8:32 am

nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.

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Re: Understanding Bond ETF Discounts

Post by bgf » Sat Mar 21, 2020 8:40 am

nisiprius wrote:
Sat Mar 21, 2020 8:19 am
bgf wrote:
Sat Mar 21, 2020 7:29 am
how should the data be interpreted to reflect this?
In my unasked-for opinion, we should interpret it this way.

Source

Last ten years:
Image

Last thirty days:
Image

If the orange line is the truth and the blue line is a lie, so be it. The amount of worry I have is equal to the amount of air I can see between the blue and orange lines on each chart.
always happy to read what you have to say. i take small issue with those charts as i do with most that dont show intraday high and low.

if those charts were more granular with intraday highs and lows, there would be far more divergence, no?

thats what im referring to. the actual 'lived experience' is not reflected in that data.

edit* for example, it would be interesting to see a chart not of closing prices but of the difference of intraday highs and lows between the two funds.
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Re: Understanding Bond ETF Discounts

Post by vineviz » Sat Mar 21, 2020 8:45 am

nisiprius wrote:
Sat Mar 21, 2020 8:19 am
If the orange line is the truth and the blue line is a lie, so be it. The amount of worry I have is equal to the amount of air I can see between the blue and orange lines on each chart.
Without (I hope) implying that one scale is right and the other wrong, here's a different way to look at the same two funds (VBTLX and BND) using a 10-minute interval to illustrate the intra-day volatility differences that I think are freaking some people out.

Image

The price of short-term liquidity has been extremely volatile, but one thing we know is that these two lines MUST converge again at some point.

Investors who neither bought nor sold during the period of divergence should be indifferent about HOW that convergence occurs.

Anyone who sells BND while they are diverged should know they are buying liquidity precisely at the time when liquidity is most expensive. If you NEED the liquidity, this is unfortunate - if for no other reason than the fact that money you need this month should NOT be in a bond fund with a 5+ year duration - but (IMHO) fair. If you panic sell when markets are volatile then, well, maybe you deserve the price you get.

And as the charts that nisiprius posted illustrate, the economic impact of this should be small for a "stay the course" investor. Even a retiree who happened to take ALL of this year's spending out of BND on Friday is maybe 0.25% worse off than a similar retiree using VBTLX.
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Re: Understanding Bond ETF Discounts

Post by bgf » Sat Mar 21, 2020 8:48 am

lol ask and ye shall receive. thanks vineviz.
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Re: Understanding Bond ETF Discounts

Post by vineviz » Sat Mar 21, 2020 8:49 am

alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Understanding Bond ETF Discounts

Post by informal guide » Sat Mar 21, 2020 9:25 am

vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
Historically, Vanguard has taken steps and actions to protect the long term buy-and-hold investor in its mutual funds - -(e.g., closing hot funds and imposing in/out trading restrictions). I would find it very surprising (and, of course, distasteful) if, in fact, they were permitting traders to profit at the buy-and-hold investor's' expense. At Vanguard the pool of assets for the total bond market portfolio and the total bond market ETF are one and the same and, I assume (but don't know definitively) that the same individual bond prices are used for the NAV calculations of both the fund NAV and the ETF NAV, given they list the price of each asset in the holdings section of the fund's annual report.

I would suspect that the key factor causing the unusually large ETF trade price to NAV discount is the wider bid/ask spreads on bond securities, coupled with a surplus of ETF sellers vs. buyers. The spreads need to be big enough for the APs to commit their capital by stepping in.

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Re: Understanding Bond ETF Discounts

Post by abuss368 » Sat Mar 21, 2020 2:22 pm

Rick Ferri wrote:
Sat Mar 21, 2020 6:41 am
Bond ETFs have been trading at discounts to net asset value (NAV) in the past few weeks, On Monday, March 16, the iShares Core U.S. Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND) traded at discounts of 4.43% and 6.17%, respectively. Over the past year, AGG and BND usually trade at average premiums to NAV less than 0.10%.

To understand better what's going on, ETF.com asked market maker Reggie Browne. I've known Reggie for several years. He is probably the most knowledgeable person alive on ETF trading. He has been making markets for ETFs since their inception.

Here is the article:

Why Many Bond ETFs Now Trading At Discounts

Here are some highlights:

"When fixed income ETFs trade at a 4% or 5% discount, it's because you're seeing stale prices in the underlying bonds, where the marketplace has fair valued them. The ETFs are giving real-time price action, where the bonds are actually trading."

"...only 20% of corporate bonds trade every day. But fair value agents, like IDC [Interactive Data Corporation], must come up with a fair value of the portfolio of corporate bonds [to create a daily NAV]. If those bonds don't trade every day, they still take a fair value, and a lot of times the prices are stale. [the computer is using old data]"

"...the bond market structure isn't doing a good job of reflecting in real-time where bonds are trading. ETFs are doing it for them."

----

In a nutshell, ETF are pricing bonds correctly. It's the NAV is wrong. So, if you bought Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) on March 16 at the NAV price, you overpaid by about 6%. If you bought Vanguard Total Bond Market ETF (BND), you bought at fair market value. Vice versa, if you sold VBTLX on March 16, you earned an extra 6% more than the market value of the bonds in the fund, and if you sold BND, you got the correct market price.

Rick Ferri
Rick -

Do you only have a brokerage account and ETFs? Do you invest in traditional mutual funds any longer?
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Re: Understanding Bond ETF Discounts

Post by Doc » Sat Mar 21, 2020 2:59 pm

nisiprius wrote:
Sat Mar 21, 2020 8:13 am
Regardless of which is "correct," the NAV or the ETF market price, it is still true that the mutual fund is required to redeem at NAV.
But if the last trade for bond "A" was at 3:00 at 100 and at 3:59 the price for similar bond "B" was up 10 to 110 then what is the NAV of "A" after close? Probably 100 since that was the last trade recorded but the ETF traders know or at least think they know that if "A" had also traded at 3:59 the price would have been 110 also.

Stale pricing that the ETF traders can account for but the fund NAV cannot.
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Re: Understanding Bond ETF Discounts

Post by Angst » Sat Mar 21, 2020 11:25 pm

Rick Ferri wrote:
Sat Mar 21, 2020 6:41 am

[Snip...]

In a nutshell, ETF are pricing bonds correctly. It's the NAV is wrong. So, if you bought Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) on March 16 at the NAV price, you overpaid by about 6%. If you bought Vanguard Total Bond Market ETF (BND), you bought at fair market value. Vice versa, if you sold VBTLX on March 16, you earned an extra 6% more than the market value of the bonds in the fund, and if you sold BND, you got the correct market price.

Rick Ferri
Yep it's amazing, although the article is not really news to anyone in the forum who has been following the variety of BH threads that have popped up over more than a week now having any combination of "ETF", "NAV", "Liquidity" and "Mutual Fund" in their subject headings and discussing this inequity or arbitrage opportunity, depending on how one looks at it. Illiquidity and stale pricing has created some unusual discrepancies, in particular between some of the Vanguard ETF/Mutual Fund "equivalents" of various bond funds.

I'm glad that the article touches on some of the shortcomings of the bond trading system (vs. equity trading) in terms of providing information to traders. Improving this might make the gaping spreads bonds have experienced recently less likely to happen.

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Re: Understanding Bond ETF Discounts

Post by TIAX » Sun Mar 22, 2020 12:53 am

vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
Can you explain how long term VBTLX investors are harmed by the panic sellers/market timers?

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Re: Understanding Bond ETF Discounts

Post by Lyrrad » Sun Mar 22, 2020 4:42 am

TIAX wrote:
Sun Mar 22, 2020 12:53 am
vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
Can you explain how long term VBTLX investors are harmed by the panic sellers/market timers?
If the ETF price is closer to the actual value of the underlying fund, then if there are net redemptions of the mutual fund, then those that are redeeming the mutual fund are getting more than the actual value of the fund, to the detriment of the remaining shareholders.

If one holds the mutual fund of a bond ETF, presumably one may be able to arbitrage this by selling the mutual fund and buying the ETF at a discount to NAV, though one may have difficulty implementing this since the mutual fund NAV is set after close.

I’ll note that Vanguard appears to be implementing fees on cash redemptions for APs on BNDX and VMBS according to this WSJ article from Friday:
Vanguard also is imposing new costs for such large intermediaries who want cash redemptions from two ETFs. This week the company imposed a surcharge of up to two percentage points on cash redemptions from the Vanguard Mortgage-Backed Securities ETF and the Vanguard Total International Bond ETF.
[...] The surcharges on cash redemptions is 0.50 percentage point right now. Vanguard didn’t charge any cash redemption fees previously.
Apparently, authorized participants are able to redeem large lots of the ETFs for cash if they want, though it seems that they are now getting charged a fee compared with receiving a basket of the underlying bonds.

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 7:00 am

TIAX wrote:
Sun Mar 22, 2020 12:53 am
Can you explain how long term VBTLX investors are harmed by the panic sellers/market timers?
The bonus being paid to the person redeeming the fund has to come from somewhere, and that only somewhere is the fund.

For example, imagine a fund with 2 shareholders, each holding 1 share. The fund has $190 in assets, each share is worth $95. The accountant incorrectly strikes the NAV at $100. 1 shareholder sells, getting $100 in cash. This leaves the second shareholder with only $90 in assets.

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Re: Understanding Bond ETF Discounts

Post by yoyo6713 » Sun Mar 22, 2020 8:10 am

So am I right to conclude that if you want to buy into munis now you should buy ETF(VTEB) instead of the mutual fund(VWLUX)?

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Re: Understanding Bond ETF Discounts

Post by gjlynch17 » Sun Mar 22, 2020 8:21 am

yoyo6713 wrote:
Sun Mar 22, 2020 8:10 am
So am I right to conclude that if you want to buy into munis now you should buy ETF(VTEB) instead of the mutual fund(VWLUX)?
Yes, if you are referring to VTEAX, which is the mutual fund equivalent of VTEB. You would own the same securities but can buy cheaper with VTEB. Similarly, if one already owns VTEAX, she can sell VTEAX and buy VTEB and lock in the discount between the ETF and NAV while still owning the same securities.

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Re: Understanding Bond ETF Discounts

Post by ChrisBenn » Sun Mar 22, 2020 8:45 am

alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
For vanguard funds, since etf's are a share class on the same underlying fund, etf holders are paying for those mutual fund premium vs market withdrawls also, right?

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 8:51 am

ChrisBenn wrote:
Sun Mar 22, 2020 8:45 am
For vanguard funds, since etf's are a share class on the same underlying fund, etf holders are paying for those mutual fund premium vs market withdrawls also, right?
Yes.

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Re: Understanding Bond ETF Discounts

Post by yoyo6713 » Sun Mar 22, 2020 8:53 am

vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
I don't know about subsidizing. If you look at the returns, ETF sellers are getting a lot less when they exit, they paid for this liqudity.

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vineviz
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Re: Understanding Bond ETF Discounts

Post by vineviz » Sun Mar 22, 2020 8:57 am

yoyo6713 wrote:
Sun Mar 22, 2020 8:53 am
vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
I don't know about subsidizing. If you look at the returns, ETF sellers are getting a lot less when they exit, they paid for this liqudity.
The ETF sellers are, indeed, paying the market price for liquidity. Open-end mutual fund sellers are the ones being subsidized.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

ChrisBenn
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Re: Understanding Bond ETF Discounts

Post by ChrisBenn » Sun Mar 22, 2020 9:04 am

Seems like it would be advantageous to sell your bond mutual funds and buy an etf equivalent right now (tax considerations aside - and assuming your account will let you do it with unsettled funds so you aren't out of the market very long) - if the etf analogue was trading at enough of a discount to make it worthwhile.

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Re: Understanding Bond ETF Discounts

Post by Gleevec » Sun Mar 22, 2020 9:35 am

vineviz wrote:
Sun Mar 22, 2020 8:57 am
yoyo6713 wrote:
Sun Mar 22, 2020 8:53 am
vineviz wrote:
Sat Mar 21, 2020 8:49 am
alex_686 wrote:
Sat Mar 21, 2020 8:32 am
nisiprius wrote:
Sat Mar 21, 2020 8:13 am
If the ETF is trading at a discount to NAV on a day when you feel like selling, and if gates and redemption fees are not in effect, then you will get more money out of the mutual fund than you would have out of the ETF. Apparently, as much as 6.67% more in Vanguard Total Bond if you happened to pick the exact wrong day.
I will point out that the 6.67% bonus being paid out to those who redeem the funds is being paid for by the other mutual fund shareholders.
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
I don't know about subsidizing. If you look at the returns, ETF sellers are getting a lot less when they exit, they paid for this liqudity.
The ETF sellers are, indeed, paying the market price for liquidity. Open-end mutual fund sellers are the ones being subsidized.
Is this effect unique to bonds, or can it be true on the equity side where mutual fund sellers are subsidized by ETF sellers? Is this also true of Vanguard funds with ETF share classes?

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 10:09 am

Gleevec wrote:
Sun Mar 22, 2020 9:35 am
Is this effect unique to bonds, or can it be true on the equity side where mutual fund sellers are subsidized by ETF sellers? Is this also true of Vanguard funds with ETF share classes?
This is true where the NAV for mutual funds are struck above the true value of underlying assets. This tends to occurs when there is poor quality pricing data. The most common occurrence is during a bond liquidity crisis.

It helps to understand that on any given day during normal times only about 1/3 to 2/3 of the bonds in a bond fund have a actual trade. In normal times this does not matter.

This happens less often on the equity side. Pricing data tends to be of higher quality. Rare is the day when there are not thousands of trades for each and every equity in a index. There was a case where this was happening for US mutual funds invested in Europe. The funds would effectively strike their NAV at noon, big news would come out, hedge funds would exploit this by putting in big orders with the mutual funds with the portfolio managers help. However, this was fraud and that loophole has been fixed.

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Re: Understanding Bond ETF Discounts

Post by Angst » Sun Mar 22, 2020 1:41 pm

Bump...

Thanks Rick for posting the link. I was pleased with how much of the interview was devoted to a discussion of specific shortcomings in the mechanics of the "bond market" as well as the potential for making improvements. Here are a couple paragraphs of dialog with Reggie Browne that I found encouraging - my underlining added:
ETF.com 'Bond ETF Discounts' article wrote:
ETF.com: How would we go about doing this?
What would the next steps look like?


Browne: There has to be an analysis done to see what's working well and what's not working well, and to root out which entrepreneurial themes people are trying to protect. Then I think they'll come to the conclusion that what the marketplace needs is more reliable, confident information in real time. It all comes down to raising confidence in the ability to transact.

There's already an SEC committee formed, FIMSAC [Fixed Income Market Structure Advisory Committee], that's looking into an analysis on market structure for fixed income. And there are some entrepreneurial enterprises, like MarketAxess and BondCliq that are trying to solve this problem, too. It's a problem that needs to be solved.

There's a lot of complexity to this. But the equity markets implemented positive changes successfully, through limit up-limit down. The next challenge is in terms of fixed income.
Godspeed to that.

informal guide
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Re: Understanding Bond ETF Discounts

Post by informal guide » Sun Mar 22, 2020 2:25 pm

ChrisBenn wrote:
Sun Mar 22, 2020 9:04 am
Seems like it would be advantageous to sell your bond mutual funds and buy an etf equivalent right now (tax considerations aside - and assuming your account will let you do it with unsettled funds so you aren't out of the market very long) - if the etf analogue was trading at enough of a discount to make it worthwhile.
This would make sense if the discounts from NAV decline. If this ETF bond discount to NAV becomes a more lasting fixture of ETF pricing, the gains would be minimal. On the other hand, if the discount grows (think closed end funds in the 80's and 90's or a regulatory tax on brokerage sales but not mutual fund transactions) gains could evaporate on sale.

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 2:44 pm

informal guide wrote:
Sun Mar 22, 2020 2:25 pm
This would make sense if the discounts from NAV decline. If this ETF bond discount to NAV becomes a more lasting fixture of ETF pricing, the gains would be minimal. On the other hand, if the discount grows (think closed end funds in the 80's and 90's or a regulatory tax on brokerage sales but not mutual fund transactions) gains could evaporate on sale.
Informal Guide, I think you post is deeply off the mark.

The root problem here is that there are 2 different methods of generating a price for the same set of assets. We have the accountant's estimate of NAV verse the market trading price. The only way that the discount grows - or even continues - is if both liquidity and price data is poor. This is a transient issue directly tied to the crisis.

informal guide
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Re: Understanding Bond ETF Discounts

Post by informal guide » Sun Mar 22, 2020 2:56 pm

alex_686 wrote:
Sun Mar 22, 2020 2:44 pm
informal guide wrote:
Sun Mar 22, 2020 2:25 pm
This would make sense if the discounts from NAV decline. If this ETF bond discount to NAV becomes a more lasting fixture of ETF pricing, the gains would be minimal. On the other hand, if the discount grows (think closed end funds in the 80's and 90's or a regulatory tax on brokerage sales but not mutual fund transactions) gains could evaporate on sale.
Informal Guide, I think you post is deeply off the mark.

The root problem here is that there are 2 different methods of generating a price for the same set of assets. We have the accountant's estimate of NAV verse the market trading price. The only way that the discount grows - or even continues - is if both liquidity and price data is poor. This is a transient issue directly tied to the crisis.
Alex, I do agree that your scenario is the more likely path. But it is not the only path. In a number of closed end funds, which are easier to value given their limited number of securities, discounts from NAV of 5 to 10% have sometimes persisted for years. I also believe that in the eventual hunt for revenue in the Federal Government, a securities tax on sales is alluring and might be applied only to brokerage trades, rather than fund trades.

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 3:21 pm

informal guide wrote:
Sun Mar 22, 2020 2:56 pm
Alex, I do agree that your scenario is the more likely path. But it is not the only path. In a number of closed end funds, which are easier to value given their limited number of securities, discounts from NAV of 5 to 10% have sometimes persisted for years. I also believe that in the eventual hunt for revenue in the Federal Government, a securities tax on sales is alluring and might be applied only to brokerage trades, rather than fund trades.
Closed end funds are - well closed end funds. A beast of a different stripe.

As a former mutual fund accountant, I can't really see any other path. If there were a securities tax, from a fund side it would hit mutual funds and ETFs about the same. Maybe Mutual funds harder because the trade the securities within the fund. EFTs do not. If it was, as you suggested, only on the client side for ETFs - the prices should still converge. The securities tax would be a bit of extra inefficiency piled on top of transaction costs. So we would see slightly wider bid/ask spreads and slightly wider market price / NAV spreads that we see today - but math would still drive the prices together.

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Re: Understanding Bond ETF Discounts

Post by Angst » Sun Mar 22, 2020 6:27 pm

vineviz wrote:
Sat Mar 21, 2020 8:49 am
Thanks for mentioning this, as I think this is a wildly under-appreciated aspect of this situation: stay-the-course VBTLX investors have been subsidizing panic sellers and/or market timers for the past eight days or so. That's a wealth transfer that would absolutely rub me the wrong way, even if only on principle, if I were a VBTLX shareholder.
vineviz, correct me if I'm wrong, but I'm thinking it probably is just the "principle" you're talking about here, and not really some significant % of ER you'd want to even bother trying to quantify. But "wildly under-appreciated aspect" sounds potentially serious. When I think about it, I'm inclined to assume that whatever expense is potentially being incurred is likely minuscule, maybe barely 1,000ths of a % point of ER? over a week or so (so far) rather than something for holders of VBTLX to be concerned about. A few other factors come to mind as well:

1) Are there net daily inflows or outflows for VBTLX these days? We have to be assuming outflows for this specific concern. And if so, how large are the outflows?
2) I imagine Vanguard often has a good handle on the expected dollar size of daily buy and sell orders for VBTLX before market close, perhaps well before close? And therefore is making transactions in the bond market that day to manage any expected net change.
3) As of 2/29, VBTLX held almost $7B in cash.
4) Perhaps VBTLX can also buy existing, discounted shares of the ETF in the open market? If anyone ought to be taking advantage of the arbitrage opportunity, why not Vanguard?

Regardless of the numbers, as you said in your earlier post (with the excellent graphic) "The price of short-term liquidity has been extremely volatile, but one thing we know is that these two lines MUST converge again at some point."

And if it happens to be time for someone to re-balance out of VBTLX into VTSAX, good for them - do it. But maybe check for a discount on VTI first? :)

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Sun Mar 22, 2020 8:01 pm

Angst wrote:
Sun Mar 22, 2020 6:27 pm
1) Are there net daily inflows or outflows for VBTLX these days? We have to be assuming outflows for this specific concern. And if so, how large are the outflows?
2) I imagine Vanguard often has a good handle on the expected dollar size of daily buy and sell orders for VBTLX before market close, perhaps well before close? And therefore is making transactions in the bond market that day to manage any expected net change.
3) As of 2/29, VBTLX held almost $7B in cash.
4) Perhaps VBTLX can also buy existing, discounted shares of the ETF in the open market? If anyone ought to be taking advantage of the arbitrage opportunity, why not Vanguard?
1. You are correct here, the penalty to mutual fund investors is probably small. However, there is no way to spin this as a positive.

2. I don't see how they could. This is a difficult thing for a active manager to pull off. Are you suggesting that they should take up active management?

3. I am missing you point here. What exactly are you trying to say. I also suspect that a lot of that cash is not what you would consider cash. Probably a fair amount of accruals.

4. This is a hard no. From a moral prescriptive it would be pretty bad to front run your own owners. Also, a bared practice by the regulations.

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Re: Understanding Bond ETF Discounts

Post by Angst » Sun Mar 22, 2020 9:48 pm

alex_686 wrote:
Sun Mar 22, 2020 8:01 pm
Angst wrote:
Sun Mar 22, 2020 6:27 pm
2) I imagine Vanguard often has a good handle on the expected dollar size of daily buy and sell orders for VBTLX before market close, perhaps well before close? And therefore is making transactions in the bond market that day to manage any expected net change.
3) As of 2/29, VBTLX held almost $7B in cash.
4) Perhaps VBTLX can also buy existing, discounted shares of the ETF in the open market? If anyone ought to be taking advantage of the arbitrage opportunity, why not Vanguard?
2. I don't see how they could. This is a difficult thing for a active manager to pull off. Are you suggesting that they should take up active management?
3. I am missing you point here. What exactly are you trying to say. I also suspect that a lot of that cash is not what you would consider cash. Probably a fair amount of accruals.
4. This is a hard no. From a moral prescriptive it would be pretty bad to front run your own owners. Also, a bared practice by the regulations.
2) I'm surely not an expert in the field, my perspective here is as a Vanguard customer. I place a buy (or sell) order with Vanguard prior to market close, so Vanguard knows before close that they are going to have to purchase (or liquidate) $x for me at the end of day. So if they know roughly before end of day that me (and a few 1,000's of others, perhaps) are going to buy/sell a net amount, that's the net amount of bonds they will have to liquidate or buy to cover that day. If it's a wash, roughly speaking, then the $ coming in would cover (roughly) the $ going out. Otherwise, excess dollars required d/t higher actual market prices than "NAV" prices would have to come out of "cash", i.e. a loss to average share holder.

3) I'm not sure what I was thinking here. FYI, Vanguard puts those billions all under "Vanguard Market Liquidity Fund", whatever that really stands for; cash vs cash + mm securities, I don't know.

4) Oh well, I guess that doesn't (and shouldn't) surprise me, although I have seen fairly small, non-Vanguard ETF's that have included in their holdings other ETF's that somewhat fit in with the overall focus of that ETF's equity style. As a Vanguard fund holder, I think I would probably be happy if VBTLX could actually buy a bit of BND when the discount is so darned high. Rules notwithstanding, does that not make sense from my perspective?

Thank you for your responses.

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Re: Understanding Bond ETF Discounts

Post by alex_686 » Mon Mar 23, 2020 6:45 am

Angst wrote:
Sun Mar 22, 2020 9:48 pm
2) I'm surely not an expert in the field, my perspective here is as a Vanguard customer. I place a buy (or sell) order with Vanguard prior to market close, so Vanguard knows before close that they are going to have to purchase (or liquidate) $x for me at the end of day. So if they know roughly before end of day that me (and a few 1,000's of others, perhaps) are going to buy/sell a net amount, that's the net amount of bonds they will have to liquidate or buy to cover that day. If it's a wash, roughly speaking, then the $ coming in would cover (roughly) the $ going out. Otherwise, excess dollars required d/t higher actual market prices than "NAV" prices would have to come out of "cash", i.e. a loss to average share holder.

3) I'm not sure what I was thinking here. FYI, Vanguard puts those billions all under "Vanguard Market Liquidity Fund", whatever that really stands for; cash vs cash + mm securities, I don't know.

4) Oh well, I guess that doesn't (and shouldn't) surprise me, although I have seen fairly small, non-Vanguard ETF's that have included in their holdings other ETF's that somewhat fit in with the overall focus of that ETF's equity style. As a Vanguard fund holder, I think I would probably be happy if VBTLX could actually buy a bit of BND when the discount is so darned high. Rules notwithstanding, does that not make sense from my perspective?

Thank you for your responses.
So, I am not going to bury the lead. The problem with all 3 of your suggestions is that it does address the root cause - The problem is that the NAV is setting the price too high, giving bonus money to those who are redeeming. And that bonus money has to come from somewhere.

2. The problem with this is that the difference is driven by the 2 different methods used to price. Even if Vanguard new this was happening - what could it do? It books are open so people know of the problem. The NAV pricing system is on rails and can't be changed in any meaningful way for months. As a index fund Vanguard would have to sell a entire basket of securities, which is hard during a liquidity crisis. So if it were to sell it would be selling closer to the lower ETF. So we are back at square one.

3.The problem isn't a lack of cash. I am pretty sure that the fund has enough of that.

4. Sorry, but I might have to go a bit basic here. Vanguard Total Bond Market Index Fund is a independent company. This corporation has multiple share classes of common stock, VBTIX, BND, etc. As a investment company it can invest in other companies via bonds or common stock. If it invests in another fund (mutual or ETF) that is fine, those are shares of common stock. What it can not do is a share buyback as you suggest. That would involve front running of its own shareholders - a big no-no. Plus other problems, which I can discuses later, but i need to be heading out to work shortly.

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Re: Understanding Bond ETF Discounts

Post by Chicken Little » Mon Mar 23, 2020 6:59 am

In practical terms, when liquidity issues result in these differences, is a defensive investor better off in the bond mutual fund if they are going to rotate from fixed income to equity after a sharp decline in the stock market?

Would the premium of selling the bond mutual fund offset the cost of holding it? Obviously the details matter, just wondering if it can be generalized?

JohnDoh
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Re: Understanding Bond ETF Discounts

Post by JohnDoh » Mon Mar 23, 2020 8:15 pm

Couple of articles on the subject:

The Fed is going to buy ETFs. What does it mean?
On Monday, after the Fed’s announcement, LQD had gained about 6% and a competitor, Vanguard's Intermediate-Term Corporate Bond Fund VCIT, +5.42%, was about 5% higher.

But Dave Nadig, chief investment officer and research director for ETF Flows, noted in a blog post Monday morning that the Fed’s purchases won’t help with the challenges facing bond ETFs right now. ETF issuers rely on third-party bond pricing services to help them determine pricing for bonds, which don’t trade frequently under normal circumstances, let alone in a crisis. Those services, often seen as imperfect despite being the best option available, help inform the price of the fund itself.
ETFs, born from 1987 market crash, are so far making 2020 less awful
“Here’s the irony. ETFs have quite literally become the market,” Nadig said. “They are price discovery.”

Angst
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Re: Understanding Bond ETF Discounts

Post by Angst » Tue Mar 24, 2020 1:59 pm

Thanks alex_686 for your responses to my 4 numbered observations. I think I understand most everything you're bringing up while at the same time it feels like we're looking at things from different perspectives, and it might just be taking things into the weeds unproductively (and unnecessarily) to expend the effort of going further into specifics. I DO appreciate and value your insights, thank you!

I would only add that perhaps these thoughts would all be moot if the bond markets were more efficient. As I already posted elsewhere in this thread, I really hope that equity market-like limit up/limit down functionality can be built into bond markets someday, as addressed in the online article Rick Ferri linked in the OP.

alex_686
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Re: Understanding Bond ETF Discounts

Post by alex_686 » Tue Mar 24, 2020 6:43 pm

Angst wrote:
Tue Mar 24, 2020 1:59 pm
I would only add that perhaps these thoughts would all be moot if the bond markets were more efficient. As I already posted elsewhere in this thread, I really hope that equity market-like limit up/limit down functionality can be built into bond markets someday, as addressed in the online article Rick Ferri linked in the OP.
As a former mutual fund accountant (which I swear is becoming my mantra around here for the past few weeks) I would hope that I would have a slightly different perspective. Maybe a bit more technical and formal. But also, I hope, trained to protect and put first the interest of the owners, a.k.a. the shareholders. Which is why this topic so miffs me - one class of shareholder getting a bonus.

I am a bit more skeptical of limit orders - but then again I am skeptical and conservative by nature. Bid/ask spreads can still be wide and be inefficient. And I think stocks will always be more efficient by a wide margin. While the bond market is 10x larger than the stock market, there are 100x more bond issues. I mean, every company might have 2 or 3 share classes but will have dozens of different bond issues. And that is not even touching the MBS, ABS, and other Special Purpose Vehicles out there. Each with their own unique set of terms.

To bend your head a bit, the biggest jump forward in efficiency and liquidity over the past 20 years has been bond ETFs.

Anyways, try to stay healthy. If you got more questions I will be around.

Angst
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Re: Understanding Bond ETF Discounts

Post by Angst » Tue Mar 24, 2020 7:21 pm

alex_686 wrote:
Tue Mar 24, 2020 6:43 pm
To bend your head a bit, the biggest jump forward in efficiency and liquidity over the past 20 years has been bond ETFs.

Anyways, try to stay healthy. If you got more questions I will be around.
We certainly have come a long way and it does makes sense to me that ETF's have had a positive effect overall for bond markets as you say.
For the time being though, I'll say salud! :sharebeer

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Re: Understanding Bond ETF Discounts

Post by Northern Flicker » Wed Mar 25, 2020 2:02 pm

I would point out, though, that when the gaps have narrowed a couple of days later for a Vanguard funds with multiple share classes, they have narrowed to an interval closer to where the mutual fund share price was when the gap was wider. Is this because the market value moved or because the gap was eventually arbitraged or some of both? It is not easy to untangle.
Risk provides no guarantee of return.

alex_686
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Re: Understanding Bond ETF Discounts

Post by alex_686 » Wed Mar 25, 2020 2:15 pm

Northern Flicker wrote:
Wed Mar 25, 2020 2:02 pm
I would point out, though, that when the gaps have narrowed a couple of days later for a Vanguard funds with multiple share classes, they have narrowed to an interval closer to where the mutual fund share price was when the gap was wider. Is this because the market value moved or because the gap was eventually arbitraged or some of both? It is not easy to untangle.
Prices, and thus NAVs, tend to lag is times of volatility. Working off of the 5 year CDX indexs we can see that volatility has increased but gamma has decreased. That is, there was a big spike as prices went haywire. Now we are hitting a new higher plateau. This has allowed NAV pricing to catch up with ETF pricing.

FYI, this is kind of my day job so I get to see some of the numbers up close. No longer a mutual fund accountant however. Not sure how much I would trust the prices to get the intrinsic value of these bonds. Liquidity and forced selling makes things more difficult.

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Re: Understanding Bond ETF Discounts

Post by Northern Flicker » Thu Mar 26, 2020 4:55 pm

I believe neither price was accurate for the underlying securities. When liquidity is very low, stale pricing data is one issue. Barriers to arbitrage is another. Both are significant.
Risk provides no guarantee of return.

Northern Flicker
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Re: Understanding Bond ETF Discounts

Post by Northern Flicker » Thu Mar 26, 2020 6:08 pm

A significant issue was with bond indices where illiquid corporate bonds were locking up the treasuries inside at steep discounts to NAV. Treasury ETFs did not have this problem by comparison.
Risk provides no guarantee of return.

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