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Thursday, July 11, 2013

Bond ETFs and MFs Behave Differently Under Market Stress

News summary by MFWire's editors

In light of the recent bond selloff, IndexUniverse's Matt Hougan compares bond mutual funds and bond ETFs in time of market stress.

For example, its easier to calculate NAV for equity mutual funds or equity ETFs but for municipal bond ETFs have no official exchange and therefore no agreed upon price. There may be months, weeks and days between trades to top it off. Bond ETFs in general require a lot of guessing, Hougan writes, and though guesses are based on reported trades and surveys of trading desks, they're still just guesses.

Bond ETFs also tend to trade at large discounts to their NAVs in times of market turmoil. Hougan explains why that is:
The reason the bond ETF trades down to $95 when its reported NAV is $100 is that APs don’t think they can actually liquidate the bonds for $100. The truth is, during illiquid markets, they may not know what price they could really get for the bonds, so they err on the side of caution. Most likely, the true “value” of the bonds if they had to be liquidated that day lies between $95 and $100. They will keep the price of the ETF as low as they can—subject to competition from other APs—when there’s uncertainty.
Despite all of the complexities, bond mutual funds aren't an improvement, Hougan writes. Though bond ETFs lose out in times of market stress because it trades at $95 vs. $100 NAV for a mutual fund, the mutual fund investors who hold out for the long term lose out:
To fulfill a redemption request, the bond mutual fund has to come up with $100 in cash. Under normal situations, it would sell “$100” worth of bonds. But we just agreed that the bond NAV isn’t real; the fund can’t actually sell those bonds for $100. To fulfill the redemption request, they will have to sell for more than the full $100.
To read more, click here.  

Edited by: Casey Quinlan

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