(Dow Jones) When it comes to bond ETFs, investors think they've got lemons. The exchange-traded fund industry has been working hard to convince them it's really lemonade.
The problem is that these funds, baskets of bonds that trade on the stock exchange, often don't exactly mirror the published value of their underlying holdings. Making matters even worse, the biggest discrepancies tend to occur at times of stress, such as the 2008 financial crisis and the more recent municipal-bond swoon. Investors that sold municipal bond ETFs at the height of last month's decline took "haircuts" of as much as 4% on the stated value of their ETF's holdings.
Bond ETFs first hit the market in 2002 and have proved a big hit with investors fleeing the stock market over the past two years. Today nearly 130 fixed-income ETFs, covering slices of the market ranging from Treasurys to more exotic Build America Bonds, hold more than $140 billion, according to the Investment Company Institute.
Fund companies insist ETFs aren't mispriced, just misunderstood. Since bond ETFs often trade more frequently than the bonds they represent, fund firms argue ETFs are actually better indicators of the market's sentiment than the quotes investors receive for the fund's underlying values, figures that in turbulent markets can amount to mere estimates based on out-of-date prices and quotes offered by large bond dealers.
"Not all bonds trade constantly," says Tom Anderson, head of ETF strategy and research at State Street Global Advisors. "The NAV"--the per share value of an ETF's holdings--"may not be as current as the price of an ETF."
Even in normal markets, bond ETF investors should expect some pricing discrepancies because of the bond market's high trading costs. In general, ETFs keep fund share prices in line with the value of their underlying holdings by offering a standing invitation to certain large, accredited investors to exchange baskets of bonds for fund shares and vice versa. If the price of the ETF floats up above the value of its holdings, these investors will buy up the underlying bonds, trade them for ETF shares, and sell those shares at the higher price.
There's a catch, however: Doing this only makes sense if the potential profit outweighs the trading costs associated with assembling a basket of up to several hundred individual bonds. That means ETFs that track easy-to-trade bonds like short-term Treasurys rarely see prices deviate more than a few pennies from their underlying values. But funds that represent markets where bonds trade less often and prices are harder to gauge can see regular mismatches of up to 2% of their value, according to a recent study by iShares, the largest ETF company.
Moreover, because estimates of ETFs' underlying values are based on the prices at which dealers offer prospective sellers, they tend to make ETF trading prices--which don't necessarily incorporate that bias--always look slightly inflated, all other things being equal.
"Most fixed-income ETFs trade at a premium in most market conditions," says Matthew Tucker, managing director at BlackRock Inc. (BLK), which owns iShares, the largest ETF brand. "The more expensive it is to trade (the underlying bonds) the larger the premium is going to be."
When bond markets are rocky, ETFs can deviate even more from the estimated values of underlying bonds than trading costs would seem to merit.
Even then, the fund industry says, ETFs typically do a better job reflecting the market's take on bond prices than the published estimates of ETFs' underlying values do. These values, calculated with the help of third-party data providers, take into account recent trading prices, quotes from bond dealers, and other market information like prices for Treasurys and interest-rate swaps. But if prices move quickly or seem volatile, those estimates can become more and more tenuous. By contrast, ETF trades represent actual transactions, arguably a better definition of an asset's value.
An iShares ETF "is trading in real time," says Tucker. "The market is going to put a price on it."
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