Discounts to NAV: How to Spot Opportunity in Bond ETFs

They're painted as a 'problem,' but not for calm investors

   

The June selloff in bonds has created a new pet boogeyman for the financial press: bond ETFs.

During the downturn, many exchange-traded funds moved to a discount to their underlying net asset values as investors’ rush for the exit caused their share prices to fall faster than the value of the underlying securities. This phenomenon sparked a flood of articles discussing the “problem” with bond ETFs.

With so much ink having been spilled to warn investors about this issue, it’s time for another look. First, a quick review.

Share Price vs. NAV: A Brief Explanation

Bond ETFs trade in the open market, as do the underlying bonds held in the portfolios. Most of the time, the price of the ETF is fairly close to the value of the portfolio’s holdings thanks to the arbitrage executed by major players. In a rapidly falling market, however, the price of the ETF can fall faster than the value of the less-liquid bonds in the underlying portfolio — a problem that is exacerbated when the ETFs providers take steps to prevent arbitrage.

This is exactly what occurred during the height of the selloff last month, resulting in the gap between NAVs and market prices — not to mention the onslaught of press coverage.

This Is an Issue Only in Certain Cases

Owning an asset that can’t be sold for its full value indeed can be concerning, but there are several reasons why this doesn’t have to represent a major issue for ETF investors.

First, funds tend to trade at a substantial discount only for relatively short intervals. For instance, iShares National AMT-Free Muni Bond ETF (MUB) — which traded at a discount of more than 3% at the selloff’s peak — became a poster child for the underperformance of ETFs relative to their underlying indices. But even with all the attention devoted to this shortfall, the severe discount only lasted for a period of days, and it had shrunk to 74 basis points by July 15.

The takeaway here is that an investor in MUB — or any other bond ETF that moved to a severe discount — only would have been hurt if they had executed a panic sale into a rapidly falling market. This is exactly the type of emotion-based decision investors should avoid anyway, irrespective of the NAV issue, so in this case, it could be argued that the seller is being duly punished for a rash, unwise approach to managing their fixed-income holdings.

And this leads to the even larger question: Who would take such a short-term approach to non-leveraged bond ETFs in the first place?

In contrast, the temporary discount is merely a bump in the road for longer-term investors.

The Upside to the Discount Problem

While most of the coverage of this issue has portrayed it in a negative light, that fails to account for the fact that investors can actually benefit when ETF share prices diverge from their NAVs. An ETF trading at a discount in a selloff is an opportunity for a longer-term investor not only to buy low, but also to pick up shares for less than their value. In this way, the calm investor can capitalize on others’ fear by picking up shares on the cheap.

The discount serves a secondary purpose, as well: It provides a signal that a market has become deeply oversold and is primed for a bounce. This, of course, is exactly what happened in the most recent downturn.

How to Find NAV

Large gaps between share price and NAV for bond ETFs are rare, but the constant stream of commentary from the Fed is likely to lead to further volatility surrounding the possibility of “tapering” in the months ahead. As a result, don’t be surprised if bond funds again move to heavy discounts before the year is out.

If you want to track of net asset values, simply add an “.IV” to the ticker in Yahoo! Finance. For instance, the NAV for MUB is MUB.IV.

This simple bit of research may provide long-term investors with an excellent entry point to establish or add to positions when the herd is galloping in the other direction.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/07/discounts-to-nav-how-to-spot-opportunity-in-bond-etfs/.

©2014 InvestorPlace Media, LLC

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