Buy Bond ETFs At Large Discounts To Net Asset Value (NAV)

Is there a reference to Ravello in the new Richard Gere movie Arbitrage?

For reasons I don’t completely understand, bond ETFs, especially ones investing in illiquid bonds such as munis, trade at a premium to the net asset value (NAV) most of the time. That means you will pay more to buy the ETF than the value of the illiquid bonds held by the ETF.

Look at these data from iShares for some of the muni bond ETFs in 12 months ended in March 2013 (the latest data available):

ETF % of days trading at premium
iShares S&P National Municipal Bond Fund (MUB) 86%
iShares California AMT-Free Muni Bond ETF (CMF) 85%
iShares S&P New York Municipal Bond Fund (NYF) 98%

During a market shakeup, however, these ETFs turn into trading at a large discount to the net asset value. Here are the same ETFs again, as of last Friday, June 28, 2013:

ETF Discount to NAV
iShares S&P National Municipal Bond Fund (MUB) 1.05%
iShares California AMT-Free Muni Bond ETF (CMF) 2.04%
iShares S&P New York Municipal Bond Fund (NYF) 2.29%

The current discounts also happen to be larger than those ETFs ever saw in 12 months April 2012 to March 2013. When a muni ETF is only expected to return 2-3% a year, a 1-2% discount to net asset value is very large.

When an ETF trades at a discount to the NAV, there are two interpretations. One theory says that the ETF is out of whack, selling at fire sale prices. If that’s the case, buying the ETF would make a profit when the panic dissipates. You profit in two ways: (1) the ETF discount disappears and the price goes back to the NAV; and (2) the NAV goes up after the panic is over.

Another theory says that the ETF prices traded in the market actually reflect the true value of the underlying assets. Because the underlying assets are illiquid, the prices used to calculate the NAV are stale. If the fund tries to sell those illiquid bonds during a market panic, they would get the same fire sale prices. Shortly as more bonds trade at new lower prices, the NAV will adjust down, catching up with the lower market price of the ETF. If this is the case, buying the ETF at a discount to the NAV won’t make you a profit. By the time the discount disappears, the NAV is also lower.

The sometimes large premiums and discounts, seemingly always at the wrong times, lead investment advisor Rick Ferri to say don’t buy bond ETFs or don’t trade them in volatile days. The premiums and discounts actually create an opportunity only for us retail investors. Here’s how you can take advantage of them:

1. In normal times, when bond ETFs trade at a premium, buy open-end bond mutual funds, such as Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX). Vanguard also offers state-specific muni bond funds for California, New York, and a few other states.

2. During a panic, when the ETFs trade at a large discount, sell from the open-end bond mutual funds to buy the ETFs.

3. When the panic is over and the ETFs are trading at a premium again, sell the ETFs and buy the open-end bond mutual funds.

Unless the large discounts persist, which isn’t likely given the history and how ETFs work, you are guaranteed to make a profit with your moves. Either the NAV will be up when the panic is over, in which case your ETFs will get a double boost, or the stale prices for the mutual fund NAV will catch up with the true lower prices, in which case you will lose less with ETFs.

I did just that last Monday. So far scenario #1 is playing out after Wall Street beat the Fed into backpedaling their plan for QE tapering. The open-end mutual fund shares I sold are up 1.7% for the week (sold low), but the ETF shares I bought are up 3.3% (bought lower).

An extra 1-2% is a big deal for bonds. It’s rare when small retail investors have an advantage over large institutional investors. The ability to buy FDIC-insured CDs and I Bonds with no interest rate risk and comparable or better yield is one. Selling open-end mutual fund shares to buy equivalent ETFs at a large discount is another. When the opportunity presents itself, take advantage of it. As I mentioned last week, don’t be afraid to switch.

[Photo credit: Flickr user Ninian Reid]

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Comments

  1. Paul Norris says

    Good advice. However, it would also be helpful if the article explained how the average investor can check the current price to NAV to confirm that a discount exists before they buy.

  2. Harry says

    Good point, Paul. I use Fidelity. After you log in, click on Research -> ETFs. On the ETF research page, enter the symbol, leave the dropdown as “snapshot” and click on Go. The current intra-day NAV shows on the left hand side of the snapshot page, near the bottom of the first section. Alternatively, in Yahoo! Finance, get a quote for ^[symbol]-IV, for example ^MUB-IV for the intra-day NAV for MUB.

  3. Dan says

    HYD (market vectors high-yield muni ETF) had an even larger discount. If you had bought and sold at the right moments last week, you would’ve got almost a 10% discount. I traded my Vanguard muni mutual fund for HYD and then switched back 3 days later and made around 3.5% in the process.

  4. John says

    It’s interesting to compare a bond ETF and a bond closed-end fund. Either can trade at a discount or premium, although a CEF does so to greater extremes.

    One difference is that an ETF can boost or shrink its number of shares outstanding frequently, while proportionately buying or selling the underlying securities. That’s an attempt to cancel the discount or premium of the ETF, and it seems to work well with liquid securities like blue chip stocks, but I’m not sure how well it works when the securities held by the fund are illiquid (which can happen with bonds, as you mention). A CEF on the other hand is pretty much stuck with the number of shares outstanding, and arbitrage isn’t very effective, so discounts and premiums can get a bit extreme — especially when there’s market volatility.

    Lately several municipal-bond CEFs like NPM have been trading at about 9% discount to NAV, so that they might be a more attractive bargain than an ETF trading at a 2% discount.

  5. Kevin says

    I took advantage of this temporary scare as well, with part of my CA int-term TE fund (VCADX) -> CMF, and part of my CA long-term TE fund (VCLAX) -> CXA. I wish I did more, but this was my first time doing this, and I was being cautious.

    How are people handling the 3-day settlement issue to get from the ETF back into the mutual fund? Using cash to get back into the mutual fund or just waiting until the ETF sale settles and being out of a fund for 3 days? At this time, I have the cash to do the former, but if I had done the trade with my entire holding of either fund I would not have. I’m reluctant to be out of either fund for 3 days.

    Thanks,

    Kevin

  6. Harry says

    Kevin – I don’t want to be out for 3 days either. I would just use cash to buy bond fund and wait for the ETF sale to settle. If you don’t have enough cash for the entire holding, do the switch in batches. That’s better for low-volume ETFs such as CMF and CXA anyway. Otherwise your trade would take up a good percentage of the trading volume for the day and affect the prices.

  7. Kevin says

    Harry, yep, that’s what I’m planning to do. Just wanted to make sure I wasn’t missing something.

    Thanks,

    Kevin

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