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Poor Man’s Arbitrage Using iNAV: HYD

Dave Nadig


Apparently the last week around here has been iNAV week. With Matt calling for their banishment , me agreeing with him (much to my dismay) and Ugo Egbunike calling us both idiots .

And Ugo’s points are all valid. INAV can be a fantastic tool, and one which smaller investors can use to make money. The action in this week’s bond market is a fantastic case in point.

Now, bond pricing is a tricky thing. As Rick Ferri pointed out today in an excellent blog over at Forbes , when the liquidity of the bond market starts getting shaky, bond ETFs can trade well below their fair value. He uses that fact as reason to suggest avoiding bond ETFs. I see it as a trading opportunity.

Let’s pick a simple example I’ve been following all week:the Market Vectors High Yield Municipal Bond ETF (HYD).

I’m not a bond master; I won’t tell you whether this week was a good or bad time to buy high-yield munis. But what I can tell you is that as a rule, it more often trades at a premium than a discount:

HYD Premium/Discount


This makes sense—bond portfolios are priced on the bid, so on a normal day, you expect the fund to trade slightly above the NAV, because the NAV represents the market’s best guess of a fire-sale liquidation price. And for most of the history of HYD, money has been coming in, not out. I bet you can guess when the money was coming out based on that chart.

HYD Premium/Net Flows




And honestly, that’s pretty much all I needed to know. Here was a fund with major redemption activity. That redemption activity did two things. First, it depressed the price of HYD as sellers flooded the market. Second, the authorized participants, or Van Eck, had to actually go into the market and sell bonds.

Think about that for a moment. They had to sell bonds. The same bonds that are still in the fund. That means those bonds traded. That means the net-asset value for HYD is solid—it’s based on real-world trades. So HYD trading down makes sense. HYD’s NAV being down makes sense.

However, there is no case in which a persistent discount in HYD to the fair value of its-now-accurately priced portfolio makes sense, which is why the mean expectation for HYD is that it should trade right around NAV, or even slightly above it.

This was, to be blunt, an irrational discount, and one that was very evident on the screen.

HYD Equity vs HYDIV Index

These kinds of trades aren’t all that common. Most often when you see a large discount on the screen, it’s in something very illiquid, and if you looked at the bid/ask midpoint versus fair value, you’d find the discount disappears. That’s been the case all week with thinly traded bond and commodity ETFs—the appearance of discounts that aren’t actually executable.

But in the bond market, things have a tendency to linger for a few days. And in this case, iNAV and NAV were invaluable tools in catching the pricing errors. It’s not dissimilar to what Matt pointed out in GYLD , but the reasoning here is even more sound—a simple portfolio, flooded with redemptions, triggering a round of mispricing until the market woke up and smelled the coffee.

At the time this article was written, the author held no positions in the security mentioned. Contact Dave Nadig at dnadig@indexuniverse.com.


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