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By Matthew Hougan and Dave Nadig

[Editor’s note: The following is the final installment of a two-part series analyzing best practices in using fixed-income exchange-traded funds in the most cost-effective manner as part of a broadly diversified portfolio. This story originally appeared on IndexUniverse.com on August 6, 2009.]

In the first part of this study, we examined the controversy surrounding the premiums and discounts in fixed-income ETFs.

The piece reviewed how and why those premiums developed. It also looked at the oft-cited case of the iShares High Yield Bond ETF (HYG) during the credit crunch of 2008. During that period, HYG traded at wild premiums and discounts to its underlying NAV, causing many to wonder if fixed-income ETFs make sense for any category of bond. (See Part 1 here.)

In this second and concluding portion of our analysis, we take an in-depth look at that question by providing a breakdown of premium/discount data in various corners of the fixed-income market.

HYG’s performance during the market meltdown is interesting, but ultimately, doesn’t tell us much about the typical experience of an investor in a bond ETF. HYG captures the most illiquid segment of the bond market, and October 2008 was a uniquely illiquid period in the history of the bond market.

To find out how ETFs perform during more normal periods, we examined the premiums/discounts for all relevant domestic fixed-income ETFs during the second quarter of 2009.

The study compared the closing bid/ask midpoint to the net asset value for the funds on each day of the quarter. It excluded Vanguard ETFs, which operate as share classes of Vanguard’s fixed-income mutual funds and thus have different trading characteristics than other bond ETFs. It also excluded money market funds, as well as actively managed ETFs, where premiums and discounts would naturally be more variable.

Finally, it excluded international fixed-income funds, since the premium/discount information here is irrelevant: Premiums and discounts are calculated by comparing the closing price of the ETF with the net asset value of the funds’ underlying holdings. For international funds, the NAV freezes when the domestic markets close. For a fund holding European Treasuries, for instance, the NAV would be based on prices at 10 a.m. ET (when European markets close), while the ETF will trade until 4 p.m. It’s not apples-to-apples.

The study shows one thing very clearly: Asset class matters when trading fixed-income ETFs.

The more liquid the underlying market, the lower the average premiums and discounts. The study also highlights a technical glitch in the bond market: ETFs tended to close almost exclusively at a premium to NAV, rarely dipping into discount mode. This is nearly baked in by design: Bond prices are marked on the “bid” when calculating net asset values, while premiums and discounts are measured based on the closing midpoint of the bid and the offer for the ETF itself.

That difference explains much of the positive bias in premium/discount distribution.

Treasuries

The place to start is with Treasuries, the most liquid corner of the ETF market. The message here is clear: Investors should not worry about premiums and discounts in traditional Treasury ETFs.

Of the 10 Treasury ETFs examined, the average premium or discount during the second quarter ranged from 0.00% to 0.12%. The absolute maximum premiums and discount were small as well, ranging from .64% to -0.61%, and staying in much tighter realms for most of the funds.

Importantly, Treasury ETFs traded at both premiums and discounts, which is what you would expect to see in a random walk when both sides of the creation/redemption mechanism are functioning. Sometimes the market closed when the ETF happened to be trading slightly above its true value, and sometimes not. There was no discernible pattern.

Interestingly, premiums and discounts got larger as you moved out the yield curve, which is exactly what you would expect given the higher liquidity of short-term T-bills.

Q2 Premiums And Discounts: Treasury ETFs

Ticker

Avg. Premium

% Positive

Largest Premium

Largest Discount

Barclays Short Treasury Bond Fund

SHV

0.02%

89%

0.07%

-0.03%

SPDR Barclays Capital 1-3 Month T-Bill

BIL

0.01%

59%

0.06%

-0.05%

Barclays 1-3 Year Treasury Bond Fund

SHY

0.01%

61%

0.08%

-0.08%

Barclays 3-7 Year Treasury Bond Fund

IEI

0.01%

60%

0.11%

-0.18%

SPDR Barclays Capital Intermediate Term Treasury

ITE

0.12%

95%

0.37%

-0.08%

Barclays 7-10 Year Treasury Bond Fund

IEF

0.03%

63%

0.23%

-0.33%

Barclays 10-20 Year Treasury Bond Fund

TLH

0.09%

78%

0.46%

-0.42%

SPDR Barclays Capital Long Term Treasury

TLO

-0.00%

52%

0.45%

-0.53%

Barclays 20+ Year Treasury Bond Fund

TLT

0.02%

50%

0.62%

-0.61%

PowerShares 1-30 Laddered Treasury Portfolio

PLW

0.04%

74%

0.64%

-0.33%

Agency Bonds

Premiums and discounts were slightly higher for ETFs tracking agency bonds, which function nearly like Treasuries (being issued by U.S.-government-sponsored agencies). These are still highly liquid markets, however, and both the average and extreme premiums and discounts were small.

Q2 Premiums And Discounts: Agency Bond ETFs

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Largest Discount

Barclays Agency Bond Fund

AGZ

0.28%

95%

0.65%

-0.32%

Barclays MBS Bond Fund

MBB

0.05%

73%

0.19%

-0.22%

TIPS

The market for Treasury Inflation Protected Securities is slightly less liquid than the market for Treasuries, and both the average and extreme premiums ticked up here. Interestingly, the iShares Barclays TIPS Bond Fund (TIP) never closed at a discount at any point during the second quarter, suggesting some limits on the redemption process.

Again, however, the average and absolute premiums were very small and likely of little concern to most investors.

The SPDR Barclays Capital TIPS ETF (IPE) performed better than TIP, with tighter average and absolute premiums.

Q2 Premiums And Discounts: TIPS ETFs

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

iShares Barclays TIPS Bond Fund

TIP

0.39%

100%

0.76%

0.11%

SPDR Barclays Capital TIPS ETF

IPE

0.05%

73%

0.19%

0.08%

Blended Funds

As you move into the big corporate/government blended bond categories, the premiums and discounts start to creep up, with some premiums rising above 1%. Three of these funds traded at a premium every single day of the quarter, with only the iShares Barclays Aggregate Bond Fund (AGG) showing more variable results.

These funds offer exposure both to Treasuries and corporate bonds, and the data suggest that the illiquid corporate exposures had an impact.

Q2 Premiums And Discounts: Blended Bond ETFs

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

Barclays Aggregate Bond Fund

AGG

0.41%

89%

0.72%

-0.18%

SPDR Barclays Capital Aggregate Bond ETF

LAG

0.65%

100%

1.20%

0.00%

Barclays Government/Credit Bond Fund

GBF

0.79%

100%

1.09%

0.46%

Barclays Intermediate Government/Credit Bond Fund

GVI

0.64%

100%

0.98%

0.26%

Corporate Bond Funds

The data on the corporate bond ETFs confirm this trading vulnerability. Premiums and discounts took off in the corporate bond market, where all four ETFs trade at average premiums and discounts greater than 2%. All four of the funds also consistently traded at a premium.

Q2 Premiums And Discounts: Corporate Bond ETFs

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

Barclays 1-3 Year Credit Bond Fund

CSJ

2.56%

100%

3.45%

1.58%

Barclays Intermediate Credit Bond Fund

CIU

2.38%

100%

3.48%

1.57%

iBoxx $ Investment Grade Corporate Bond Index Fund

LQD

2.21%

100%

3.95%

0.34%

Barclays Credit Bond Fund

CFT

2.20%

100%

2.93%

1.27%

High Yield

For high yield, the premiums get more variable. While the average premium shrinks, the absolute premiums and discounts increase. Again, the vast majority of days saw premiums and not discounts.

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

SPDR Barclays Capital High Yield Bond ETF

JNK

1.87%

93%

4.51%

-0.76%

iBoxx $ High Yield Corporate Bond Index Fund

HYG

2.80%

90%

7.03%

-0.73%

PowerShares High Yield Corporate Bond Portfolio

PHB

1.58%

94%

4.5%

-0.79%

Munis Tell The Tale

The municipal bond market is notoriously illiquid. As a result, ETF providers have taken different approaches to launching municipal bond ETFs, with some offering traditional in-kind creations and others offering APs the ability to do “cash creates.” In a “cash create,” an AP delivers cash to the fund in exchange for shares, rather than buying up the underlying holdings of the fund itself and delivering that basket in return for shares.

For this study, we examined the returns of 16 muni bond ETFs: three from Invesco PowerShares, four from Barclays Global Investors, four from State Street Global Advisors and five from Van Eck. Of the 16 funds, five use the traditional “in-kind” creation/redemption methodology: the four iShares funds from BGI and the Market Vectors High Yield Muni ETF (HYD) from Van Eck. The remaining 11 funds use a cash creation process, although they still rely on in-kind redemptions.

The data are unequivocal—cash creations work. The five ETFs that use in-kind creations had average premiums and discounts between 0.79% and 2.82%. They traded at a premium every day of the second quarter. For the cash creation funds, average premiums and discounts varied between just 0.015% to 0.56%. Moreover, those premiums and discounts varied, with all of the funds experiencing both premiums and discounts, and one fund – the Market Vectors Long Muni ET—trading at a discount more than 65% of the time.

Fund

Ticker

Avg. Premium

% Positive

Largest Premium

Smallest Premium

IN-KIND CREATIONS

S&P California Municipal Bond Fund

CMF

1.72%

100%

3.14%

0.18%

S&P National Municipal Bond Fund

MUB

0.79%

100%

1.68%

0.17%

S&P New York Municipal Bond Fund

NYF

1.59%

100%

5.37%

0.25%

S&P Short Term National Municipal Bond Fund

SUB

2.82%

100%

4.26%

1.91%

Market Vectors High Yield Muni

HYD

1.90%

100%

3.74%

0.15%

CASH CREATIONS

SPDR Barclays Capital California Municipal Bond ETF

CXA

.51%

90%

1.36%

-.52%

SPDR Barclays Capital Municipal Bond ETF

TFI

.11%

79%

0.52%

-.51%

SPDR Barclays Capital New York Municipal Bond ETF

INY

.015%

52%

4.14%

-3.37%

SPDR Barclays Capital Short Term Municipal Bond ETF

SHM

.09%

97%

0.39%

-0.06%

Market Vectors Pre-Refunded Muni

PRB

.24%

76%

1.61%

-0.45%

Market Vectors Short Muni

SMB

.56%

95%

1.95%

-.3%

Market Vectors Intermediate Muni

ITM

.38%

92%

.92%

-.82%

Market Vector Long Muni

MLN

-.25%

35%

1.20%

-2.03%

PowerShares Insured National Municipal Bond Portfolio

PZA

.19%

89%

1.23%

-.30%

PowerShares Insured New York Municipal Bond Portfolio

PZT

.06%

70%

0.81%

-.23%

PowerShares Insured California Municipal Bond Portfolio

PWZ

.15%

78%

1.18%

-.36%

The cash creation data, together with the data showing tighter premiums and discounts in more liquid markets, argue against the notion that these funds are providing price discovery. The premiums and discounts that occur in most bond ETFs are driven by the illiquidity of the underlying bonds. If you remove that illiquidity either by focusing exclusively on liquid markets or using a cash creation mechanism, the premiums and discounts largely disappear.

Note, of course, that a cash creation will not prevent a fund from trading at a discount. All of these funds do in-kind redemptions—if an AP wants out, they’re getting a pile of individual bonds in return, not a check—which means the funds are still exposed to the potential for trading at a discount.

The Bottom Line

What does all of this mean for investors?

For starters, the data show that premiums and discounts are not an issue for liquid markets like Treasuries. Treasury, TIPs and agency bond funds trade at tight spreads to their NAV. Although they are not studied, it’s reasonable to expect international Treasury ETFs with significant asset and trading volume also do a good job of estimating the fair value of their underlying markets.

As you move into less liquid corners of the market, however, premiums and discounts become an issue. Many of the funds in this study closed at a premium every single day of the quarter, and the variability of that premium was relatively small. That consistency means you’re unlikely to pay a premium when you buy, but then receive a discount when you sell.

What could happen, however, if investors started redeeming these funds en masse?

The data show that there is some inefficiency in the creation-redemption mechanism; that’s why funds that use in-kind creations in illiquid markets tend to trade at a premium, while funds that use cash creations tend to trade at a discount. If the fund flows went against these ETFs, it’s not clear what would stop them from swinging to a discount.

In normal circumstances, however, bond ETFs do seem to provide a level of granularity and open up unique asset classes at a level that’s not available anywhere else. For investors looking to more illiquid corners of the market, it will pay to keep an eye on premiums and discounts. Otherwise, they might run the risk of overpaying on the high end when buying—or, sell too cheap when they’re getting out.

Original post

Source: Practical Ways to Hold Down Costs with Bond ETFs