Bond ETFs Trade At Discount To NAV

The credit crisis has suddenly made certain areas a lot more interesting than they normally would be: just look at commercial paper and bond exchange traded funds (ETFs).

Record volatility in the markets has wound up creating a gap between the value of bond ETF holdings and what the ETFs are trading at on the market, reports Trang Ho for Investor’s Business Daily.

Jim Wiandt for Index Universe wrote earlier this week about the iShares Lehman Aggregate Bond (AGG), which had an 8% discount to the NAV last week. AGG holds a mix of Treasuries, mortgaged-backed securities, corporate and industrial bonds.

Response to a bond ETF trading more like a closed-end fund (CEF) and bought at a discount, as Murray Coleman suggested, is worth examining, but Wiandt says there are big differences. With a CEF the underlying price is somewhat known, and trading at a premium or discount is more indication of how the fund is doing. With a bond ETF, the underlying index does not reflect the actual price of the underlying.

The ETF is effectively serving as the price discovery mechanism for essentially unknowable markets. What the market is saying on pricing is a much safer bet. So, as far as a bond ETF goes, the reason an investor put their money there is for safe keeping, and if the action going on within the fund is a mystery, than it depletes the entire purpose.

Because of how they’re structured, ETF prices will always vary slightly from their indicated net asset value (NAV), but the widening seen in bond funds really came as market volatility spiked in September when Lehman Brothers failed.

As more control comes into the markets, we’ll begin to see greater liquidity and the discount to NAV gap will ultimately close. But it doesn’t mean that the value of the bonds can’t continue to fall.

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