Uncertainty about the corporate stock and bond markets is fueling growth in exchange traded funds, particularly bond exchange traded funds, according to a recent CNBC.com post by Jeff Cox. High-yield corporate bond funds comprise 10 percent of the total exchange traded fund market, up from 1 percent two years ago, while high-grade bond funds comprise 15 percent, up from 6 percent in 2008, according to the article (citing BofA Merrill Lynch Global Research).
But investors should be cautious. It bears repeating that bond exchange traded funds carry hidden risks. In a recent Wall Street Journal article, Sam Mamudi cautioned investors seeking safety in bond exchange traded funds to be aware of hidden risks that can magnify the losses and limit the gains in such investments. See “Bond ETF Buyers Must Stay on Guard for Hidden Risks,” March 1, 2010.
Exchange traded funds are generally regarded as liquid, transparent investment and trading vehicles. But that reputation is only valid for the large, high-volume funds like the S&P SPDR, and not for other less liquid exchange traded funds. Bond exchange traded funds, in particular, are less liquid than most investors realize, and, as a result, the share price, dictated by market demand, is often different from its net asset value. In other words, investors often buy and sell such shares at a premium or discount relative to the net asset value.
Experts agree. The problem is “an inherent flaw in non-Treasury bond ETFs,” said Matt Hougan, managing director of ETF analytics for Index Publications. “The corporate-bond market is notoriously illiquid.” And given ETFs’ need for liquidity, he said, “it’s a square peg in a round hole.”
The growing popularity of bond exchange traded funds have created demand that pushed shares to premiums. If interest rates start to rise, however, many investors who bought bond exchange traded funds at a premium could end up selling them at a loss.
In his article, Mr. Mamudi points to SPDR Barclays Capital High Yield Bond ETF (trading symbol: JNK) as an example of how bond ETF share prices can move differently to their value. As of Friday, Feb. 19, the SPDR shares traded at almost a 1% premium to net asset value. By Tuesday afternoon, the fund’s shares traded at a slight discount to NAV. Moreover, by mid-afternoon on Tuesday, the fund’s share price had fallen about 1% from the open while its NAV, the measure of the value of its assets, was up 0.6%. Several days later, the shares were back at a premium, closing at $38.79 compared with their NAV of $38.34.
In the fourth quarter of last year another high-yield bond exchange traded fund, (HYG), posted both premiums and discounts to its share value. On Dec. 14, the premium peaked at 2.15%, while on Oct. 1 it was trading at a discount of 0.9%. In one quarter, the exchange traded funds saw only five of sixty-four trading days when the share price was within 0.5% of its net asset value.
The swings were even wider in the first quarter of 2009. The iShares fund had several days during that period when premiums were more than 6% higher than the net asset value and also days when discounts were greater than 3%. In the same quarter, SPDR Barclays Capital High Yield Bond ETF swung from premium of more 12% on Jan. 5, 2009, to a discount of 4.9% on March 2.
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