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Commentary by Rich Powers, Vanguard head of ETF product management and Scott Johnston, Head of Portfolio Review Department, Americas
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). When the gap is positive (that is, when the market price is greater than the NAV), it’s called a premium. A discount occurs when the NAV is greater than the market price. 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 in Vanguard Total Bond Market ETF (BND)
Notes: The chart depicts the frequency of premiums and discounts of various sizes between the market price and the net asset value of Vanguard Total Bond Market ETF between the fund’s inception on April 3, 2007, and March 16, 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.
Vanguard Canadian Aggregate Bond ETF - VAB
Notes: The chart depicts the frequency of premiums and discounts of various sizes between the market price and the net asset value of Vanguard Canadian Aggregate Bond ETF between Dec. 6th, 2011, and March 17, 2020. Premiums and discounts are based on end-of-day market prices and NAVs. On 2,016 of 2,067 trading days—98% 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 0.4% on just 10 days.
ETFs as shock absorbers
Bond ETFs serve as a vital source of price discovery and as “shock absorbers” for liquidity during relatively illiquid periods. A large majority 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, we remind ETF investors: Avoid trading at or near the beginning and end of the trading day if possible and consider using limit orders, which are executed only if the market price meets or exceeds a threshold that you select. And, if you don’t have to trade during a period of such volatility, don’t---that might be the best approach of all.
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