Largest Bond ETF Now Trading At a Massive Discount

In a world where my average equity holding moves in a 10% daily range, very little should surprise me.  I would like to share with you, however, something that makes absolutely no sense.  The world's largest bond ETF, and one of the largest ETFs overall, iShares Lehman Aggregate Bond Fund (AGG), is trading at an 8.9% discount.

For those not familiar with the ETF, you can visit the iShares website to learn more.  It is designed to replicate the most popular bond index, the Lehman Aggregate.  It has over $9 billion in assets invested in 174 securities that replicate the index.  Total annual expenses are 0.24%. 

In its 5 year history, the NAV has tracked the index precisely (after accounting for expenses).  Normally, the closing market price has been within 0.5% of the NAV since inception.  I had noticed earlier this month some more volatile trading during the day and observed that the discount had widened to about 3% as of 10/09 (not enough to justify giving much thought), but the floor fell out yesterday.  It shows up in the longer-term, since-inception chart below (note that the NAV is 96.99):

(click to enlarge)

 

What is going on?  I believe that several factors could explain why someone is willing to sell something that is worth 97 for 88.4. 

First, note that the ETF made a new all-time low, and this may have engendered some panic selling.  The overall underlying index it tracks has been hurt by its exposure to corporate bonds this year, with only a little offset from the Treasuries.  Through 10/10, the total return of the index is almost -1% (so the "price" return must be close to -6%).  The above chart doesn't reflect that holders of the AGG get monthly income as well. 

Second, many "closed-end" funds are trading at historic discounts, including ones with junk-bonds or munis as the underlying securities in which the funds invest.  This is a time people are selling today for what they can, in fear that they will get less in the future. 

Third, I would imagine that there is, in general, selling pressure by what I believe are the primary holders (and typical buyers) of the AGG, individuals and money managers who run separate accounts.  Perhaps combining all these points, one can conclude that someone has been either forced to sell or is willing to sell in fear that this ETF could move to an even bigger discount.

This makes no sense!  Ultimately, there is an arbitrage here, though it requires one to be willing to do it for a minimum of 100K shares (that would cost almost $9mm).  Additionally, there is a 2% fee for "redemption". 

I confirmed with iShares that this mechanism is currently in effect.  One would receive a portfolio of 174 securities as well.  Given that AGG typically trades 600k shares per day (though 1.5mm yesterday) and that most people aren't set up to receive a basket of securities, it isn't surprising that such an anomaly could occur over a short period of time.

It appears that in the short-term, the number of sellers overwhelmed potential buyers (given the surge in volume).  With professional investors fighting so many fires, I am not surprised that this could slip through the cracks.  They may not be the ones able to take advantage of this fire-sale.  In fact, they may themselves be sellers as they rebalance to correct asset allocations (since stocks have fallen so sharply relative to bonds).

Why shouldn't we expect AGG to trade at a steep discount similar to other "closed-end funds"?  First, unlike the steeply discounted muni and high-yield bond funds, AGG has a redemption process.  Second, the annual fees of just 0.24% as well as the passive nature of the fund preserve more of the underlying asset value.  Third, we aren't seeing this phenomenon in other bond ETFs run by iShares, though it persists at the smaller Vanguard Total Bond Index Fund ETF (BND) to a lesser degree (5%).  Fourth, one would expect that holders of bond mutual funds (even a large passive one at Vanguard) would consider selling out to buy this.  After all, while I expect the gap should close quickly, even if it took 3 years, very few actively managed funds would be able to return index + 3%.  Finally, this must be an embarassment to Barclays, which runs iShares.  They have a large vested interest in making sure that investors don't come to view ETFs as having this type of NAV discount risk.

This is an opportunity certainly for longer-term fixed-income investors (buying "the market" at a large discount), but it is certainly potentially an opportunity for a trader.  Yes, in this crazy market, an anomaly that might ordinarily not persist for long could end up taking a while to reverse, but this one, given the redemption process, seems unlikely to endure.

Disclosure:  Long AGG

Comments

[Topcat]

I got out at $97...had moved $ into AGG for safety, only to see it steadily drop. Good thing I got out and went to cash.

2008 Oct 11 04:33 PM

[Elwood Blues]

Top Cat, you were definitely on top of it.. I'm out at $88, one of the bigger losses for the year in what I thought was a pretty safe place to be parked.

2008 Oct 11 05:43 PM

[BxCapricorn]

I'm surprised that the author did not review the conditions under which a bond fund would drop in value. Just like the brokers that sell municipal bonds to retirees, baiting them with tax advantages and interest rates, they imply that bonds do not lose their face value. Everything can lose value, and this article's failure to review that undermines the author's assertion.

2008 Oct 11 06:28 PM

[BxCapricorn]

From a typical bond fund disclaimer:

"Risks include interest-rate risk, market risk, credit risk, foreign security risk, and prepayment risk. A decrease in interest rates usually causes an increase in value of bonds. An increase, or the expectation of an increase in interest rates generally causes a decrease in the value of bonds."

I'm sure there are other bond funds that depend on other specific conditions. Anyone wish to add to this thread?

2008 Oct 11 06:33 PM

[Alan Brochstein]

BxCapricorn, my point isn't that it could drop in value. Did you read the article? The market price is substantially below the intrinsic value of the underlying assets despite the fact that there is a mechanism to keep it roughly in line via the Redemption process (page 4 of the prospectus). In a former life, I was a professional bond-trader - I understand that the underlying assets can change in value.

2008 Oct 11 07:03 PM

[Brian Shriver]

This is an interesting article - it will be interesting to see how it develops. We are seeing a few oddities in the ETF market, but this is one of the most surprising. Have you talked to anyone at IndexUniverse about this?

Thanks, and keep us informed!

2008 Oct 11 07:27 PM

[couldashoulda]

I believe AB is pointing out that the ETF is at a discount to the total value of the 174 bonds in the index. Each of the 174 would of course have the exposure you identify, but the article concerns "tracking error" which seems to be more prevalent in ETF's given reason volatility, especially in commodities.
Same thing as a closed end fund

2008 Oct 11 07:30 PM

[Ray Lopez]

Pretty cool, though how to perform arbitrage in a violent market like on Friday, where ups and downs occurred in minutes (especially with the US Govt Plunge Protection Team working) is beyond me. Maybe if you have a proprietary seat on some exchange it could work.

2008 Oct 11 07:35 PM

[Alan Brochstein]

Brian, I have spoken only to my institutional clients and directly to an iShares representative. He informed me that they had received a ton of calls. If I understand the dynamics correctly, this won't persist for long. As I wrote above, though, lots of fires to put out, this one isn't the most pressing. Theoretically, though, for those who don't understand my point, someone with $8.5 billion dollars could buy the whole fund and turn around and exchange it for $9.4 billion (i.e make almost $1 billion, less the 2% fee).

2008 Oct 11 07:58 PM

[Halfempty]

problem is you couldnt sell the $9.4 Billion at anywhere near that number if your life depended on it. There is a shortage of buyers and just because the last quoted trade was at that price doesnt mean you coulg get that price if you showed up with size to sell

2008 Oct 11 08:13 PM

[Alex_G]

Alan, did you see the Corp bond mkt on Fri?? Our corp trader was buying A and AA credits (non financial) at 8-12%. Check TRACE on some of the bonds held in the Trust and see if the disco is real.

2008 Oct 11 08:16 PM

[Romeo Fayette]

Alan, let me summarize the impetus for this discount as I've come to understand it:
ETFs occasionally unhinge from the value of their underlying assets when there's crowding-in/out. This happens for 2 reasons...
1) The imbalance of buyers & sellers of the physical ETF shares in the open market creates wider bid/ask spreads
2) Even larger imbalances of buyers & sellers force ETF reps to redeem or purchase proportional chunks of the underlying portfolio in order to maintain a liquid market in the tracking ETF shares? To redeem, for example, reps purchase ETF shares on the open market, pass them thru to the custodian--who holds the stock certs or bonds for the underlying portfolio. The custodian exchanges those ETF shares for the corresponding basket of stock/bonds, which the rep must flip on the open market.
Authorized reps are motivated by arbitrage, because they can purchase ETF shares at a discount, then sell the basket at market price. This happens to mutually benefit ETF shareholders because it keeps share supply/demand (bid&ask) in balance and therefore in line with NAV.
This tells me that there's illiquidity in the market for the underlying basket of securities, hence iShares reps cannot flip the underlying bonds on the open market, meaning they can't redeem ETF shares to rebalance supply to meet waning demand (as sellers are overwhelming buyers).

2008 Oct 11 09:38 PM

[Alan Brochstein]

Halfempty, it wasn't just the "last quoted price". There was selling pressure all day. As I mentioned in the article, 1.5mm shares traded ($140 mm) compared to the normal 600k.

Alex_G, you do raise a good point, but the discount seems then it would be greater on a pure corporate bond ETF than one that includes a lot more MBS and Treasury securities. CFT, which is a rather small ETF, closed at 77 compared to an NAV of 86 (slightly wider). That one is 100% corporate bonds compared to AGG being just 20% or so. I appreciate your observation, though - that NAV could be somewhat suspect.

2008 Oct 11 09:40 PM

[cma]

Author hit on answer and then ignored it. Professionals who would normally arbitrage out the discount have much bigger problems on their hands: survival. Amateur investors can buy similar CEFs at 30% discounts.

2008 Oct 11 09:40 PM

[Alan Brochstein]

CMA CMA, I don't believe I ignored it at all. I believe that due to market conditions, this situation may persist somewhat longer than one might normally assume. I am unaware of a large passive ETF with open redemption/creation trading anywhere near this kind of discount. As I acknowledged in the article, there are lots of really cheap closed-end funds, but there isn't a mechanism to arbitrage the differences. An investor is subject to high fees (on the NAV, by the way) as well as potential mismangement by the active manager. I am not trying to make a judgment - they are probably both ultimately great buys. AGG is just a safer one.

2008 Oct 11 09:46 PM

[Romeo Fayette]

...Building on that conclusion, you would expect that either shares will be redeemed throughout Monday 10/13 OR buyers will crowd-in to take advantage of the arbitrage. The risk is as follows:
10% of the fund's assets can be invested in assets not included in the Lehman US Aggregate Bond Index including other bonds and high-quality Barclay's MMFs. If the fund's assets are leveraged, the loss in value of some/all of these ancillary 10% assets would be magnified to reduce NAV by marginally more than their percent contribution to the portfolio.

2008 Oct 11 10:12 PM

[Jeremy Hellman]

could it have anything to do with the Lehman sponsorship ?

2008 Oct 11 10:14 PM

[wunderhof]

Look at the table, lifted from iShares, showing the make-up of AGG. Perhaps the FNMA, GNMA, and FHL bonds' pricing doesn't reflect all of the risks that these securities may carry.
Top Sectors as of 10/9/2008 Trading Information
25.50% U.S. Treasury
17.57% FHLMC
16.84% FNMA
11.68% US Agencies
9.62% Financial Institutions
8.40% Industrial
3.91% Non-Corporate
3.59% GNMA
1.93% Utility
0.35% S-T Securities
Related Index N/A
NAV Per Share AGG.NV
Und. Trading Value AGG.IV
Shares Outstanding AGG.SO
Est. Cash AGG.EU
Total Cash AGG.TC
CUSIP 464287226
Options Available

2008 Oct 11 10:26 PM

[Topcat]

manyathought: that is one of the reasons I got out...I thought maybe the "Lehman" name was scaring away the smaller investor who did not know better.

2008 Oct 11 10:50 PM

[berberick]

you guys are funny , it has NOTHING to do with Lehman ! I shares pays a small fee for using a Lehman trademarked index . It has nothing to do w/ Lehman . What Alan is trying to say is [ I think ] is that we are seeing a severe credit crunch which will be a great trading or investing opp. I like the article , if you already owned it , well that sucks . I would not sell , probaly add a little to my position . People who sell in fear create great investing and trading opp. for savvy people .

2008 Oct 11 11:05 PM