Where Are Bond ETF Premiums & Discounts Heading?

• By Kyle Waller
• On 3:00 am EST, Friday February 20, 2009

Among the worst performers during the ongoing credit crisis have been the lowest-quality bond issues and the exchange-traded funds that hold them.

Credit quality, credit risk and credit liquidity problems were completely reflected in bond ETFs through their total return and premium/discounts to net asset values.

If in the near future the market volatility subsides and credit becomes more available, it makes sense that bond ETFs will begin to experience more liquidity and be able to reflect more closely the prices of their underlying holdings.

As this happens should we expect the premiums and discounts of bond ETFs to settle to normal levels?

Taking A Look At Junk's Characteristics

High-yield bond ETFs are among the most volatile bond funds, experiencing drastic sudden price decreases, along with alarming discounts to NAV.�Meanwhile, they faced the brunt of the flight to quality among investors.�Shown below is the return from November 14, 2007 through February 17, 2009, data from Morningstar.

The graph above of three high-yield bond ETFs tells the story well of the turmoil during the fourth quarter of 2008.�During this time bond ETFs saw huge discounts to their net asset values (NAV).� Slight premiums and discounts to NAV are common to all ETFs since ETFs trade separately from the NAV at market values.

Bond ETFs have a tendency to normally trade at greater bands around their net asset values due to liquidity and fair pricing issues in the underlying bonds.

There has been a lot of debate and research done to examine whether bond ETFs can function properly -- that is, follow the price of their underlying bonds.

The problem this time turned out to be stale prices in the underlying bonds. And interestingly, the bond ETFs -- which at the time were trading shockingly lower than their net asset values -- were acting as price discovery mechanisms.

In short, the market during some of the worst parts of the credit crisis was reflecting the price of the underlying holdings in the ETF, even though there was close to no trading or price-setting over the exchange for the individual bonds.

Heather Bell, in her article, "Bond ETF Spreads Cause Concern," published in the December issue of ETFR, explains the spread issue fully with many experts' options on the issue.

The Spread Between Bond ETFs�

In the graph below is the problem high-yield bond ETFs faced, separating from their NAV values in huge percentages during the worst times.

The discounts represented by negative values shows a risk not often thought of when investing in ETFs, the potential for the market price to not reflect the value of the underlying basket of securities.

In the case of bond ETFs most recently, it appears that the ETF market prices did in many ways reflect the value of the underlying holdings where the NAV could not.

The analysis of the overall bond ETF market -- finding each specific thing that worked and did not work during the period in 2008 where bond ETF spreads were at their extremes -- is difficult, to say the least. But most bond ETFs, especially the three high-yield funds, are passive investments with no manager risk. This has appeal for several reasons to variety kinds of investors at various levels of market participation.

The concern is whether the execution of the bond index worked and will continue to work in the future.� Since ETFs depend on market makers taking advantage of premiums and discounts to NAV, the underlying liquidity and pricing is always a concern and will be no matter if an investor owns the bonds through an ETF or directly.

The question is whether high-yield ETFs will soon return to trading around normal bands about their NAVs.� As we see in the graph, all three high-yield ETFs have been getting closer to trading nearer to NAV but have yet to return to long-term averages.

This may be the result of market conditions remaining volatile and weary of credit risk.

In the above graph, it is obvious that the PowerShares ETF, PHB, which has an average credit quality similar to the two other ETFs, displayed the largest discount to NAV during the month of September in 2008.� Each of the high yield ETFs, despite being similar in quality and other features, track there own indexes, which hold completely different underlying bonds.

Bond ETF Adds Competitors To Portfolio

An interesting note is that PowerShares High Yield Bond (NYSEArca:PHB - News) for a short-time held the SPDR Barclays Capital High Yield Bond (NYSEArca:JNK - News) and the iShares iBoxx High Yield Bond Index (NYSEArca:HYG - News) as part of its creation unit to better access the index's bonds.

The two ETFs are no longer part of the underlying holdings but as of the end of 2008, PHB held 5.01% in JNK and 4.77% in HYG, according to Morningstar.

This shows that�ETFs are a tool that they can be utilized by other ETFs to fulfill their index tracking objective -- especially in extreme circumstances.

Secondly, there was a disturbance in the underlying holdings which lead them to hold the ETFs instead of individual bonds.� The fact that the PowerShares ETF, PHB, had such extreme premiums and discounts on certain trading dates shows problems with the underlying basket of bonds that the other high yielding ETFs did not have.

That could explain why management needed to add the two competing ETFs to their creation unit.

As the chart below shows, the three high-yield bond ETFs have similar characteristics and quality. All three are considered low quality; intermediate bond funds which track their respective indexes.

Even though they have many similarities and returned around the same performance during normal conditions, during the credit crisis vast differences in performance was seen.

As we can see below, the differences did not come from average qualities but happened because credit problems were realized in underlying holdings.

Becoming familiar with how the ETF and its index will perform and function in extreme market conditions is important by studying the premium and discounts the ETF has to NAV and total return over abnormal market conditions.

Last year was a test for bond ETFs and gave a way for investors to look deeper into their functions and better understand the total picture of high-yield bond ETF risks.

Name	Ticker	Ave Credit Rating	Duration	Expense Ratio
PowerShares High Yield Corporate Bond	PHB	BB	4.7	.50%
SPDR Barclays Capital High Yield Bond	JNK	B	4.1	.40%
iShares iBoxx High Yield Corporate Bond	HYG	B	4.7	.50%
Data:Morningstar 12/31/2008

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Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He invites comments and suggestions for future columns at:�kyle@wiserinvestor.com.