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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