Largest Bond ETF Now Trading At a Massive Discount 39 comments
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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
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This article has 39 comments:
"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?
Thanks, and keep us informed!
Same thing as a closed end fund
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).
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.
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.
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
I think you are mistaking a floor for the trap door. The lifeline you're reaching for -- it's a noose.
Please explain?
Mr. Brochstein has identified a reasonable arbitrage opp. If AGG (the ETF, not its underlying portfolio) is pricing as a forward indicator (so to say that the portfolio's securities have yet to reflect some present or future credit/interest risk), there may be a "trap door," but given its severe discount to NAV, a cushion for downside risk is conveniently priced in for us.
There're extraneous factors at work here, like an inability of iShares' authorized reps to redeem shares because they cannot sell-off the underlying securities due to bond market illiquidity --OR-- the unmanageable volumes of redemptions required.
berberich,
See the following. IT MAY BE THE EXTRANEOUS FACTOR THAT THIS ARTICLE IS LOOKING FOR...
www.indexuniverse.com/...
On Oct 11 11:11 PM Curbs-In wrote:
> Alan,
>
> I think you are mistaking a floor for the trap door. The lifeline
> you're reaching for -- it's a noose.
I think that I have identified in the original article almost all of the underlying factors. I appreciate those of you who shared your opinions, as I learned that I omitted one factor: Bid-offer spreads have widened significantly, which contributes to some uncertainty regarding the true value of the NAV. Remember, though, that the illiquid bonds are primarily the pure corporate bonds, and they represent about 20% of the portfolio. Let's say that they are off by 10% - this would account for just 2% of the discount.
First, some of the closed-end funds surely could prove to be fantastic investments. Remember, though, that their managers get paid on the NAV, not the stock price. They have a disincentive to reduce the size of the ETF - it costs them money (i.e tendering for shares on the open market). I don't follow that market so closely, but I recall a lot of shareholder suits in the past.
As far as buying the super-duper cheap closed-end funds and shorting the merely heavily discounted ETF seems foolish to me. Recall that the fees are much higher (over 5X, on an annual basis) for what you would be buying. Additionally, you are subject to active manager performance. Perhaps most importantly, you are assuming a great deal of risk known as "basis risk": You are short Treasuries, mortgages and investment-grade corporate bonds to go long either municipal bonds or junk bonds. I am not trying to make a "value" call on your proposed trade but rather point out some reasons that it isn't the lay-up that you perceive. I have friends and clients who have been buying the 30% discounted funds. Of course, they were buying them when they were at 15% too.
BORROW $8.5 Billion, buy the ETF, then claim you are underwater and need 'saving'. Sell to the FED at $9.4 Billion, repay loan.
Retire.
All explained here folks
www.indexuniverse.com/...
"Bond ETFs Taking Divergent Paths In Murky Markets"
Matthew Tucker is head of investment strategy for fixed income at Barclays Global Investors in San Francisco. IndexUniverse.com caught up with the busy bond executive on Thursday to find out how the ongoing credit crunch is impacting iShares' exchange-traded funds focusing on fixed-income markets.
Time has sorted this out itseems, though I suspect you expect to see a recurrence..., and more hangings