Have you ever wondered why the price you pay for an exchange traded fund (ETF)1 can be different than the net asset value (NAV)2? We have written in the past about these two different pricing sources for ETFs, market price and NAV. Several factors can cause an ETFs trading price to diverge from its NAV (defined as a premium3 or discount4). In ETF trading, different prices are not only expected, but show the ETF structure is functioning properly. In this article, we’ll look at a few examples of potential price differences that are unique to fixed income ETFs due to both structural and technical factors.

Example #1: Fixed Income ETFs and NAV
Most fixed income mutual funds and ETFs use the bid side of the market — or the price at which you can sell a bond — for calculating the NAV. Therefore, the NAV is reflective of the prices associated with selling the underlying fixed income holdings. This methodology will therefore underestimate the cost of buying the fixed income holdings, which would be closer to the offer side of the market. For an ETF investor interested in buying a fixed income ETF, the bid side NAV calculation will lead to the appearance of a premium because the ask (offer) price of the ETFs market price is reflective of the costs to buy bonds, while the NAV is being calculated using the price to sell the bonds.

Example #2: Fixed Income ETFs and Closing Time
There are also market closing time differences between the US Treasury market and the US equity market, which can affect the pricing of fixed income ETFs. As some investors may not be aware, the US Treasury market closes at 3PM EST but fixed income ETFs continue to trade like stocks for another hour, until the equity market close at 4PM EST. Thus, the premium or discount of fixed income ETFs can occur because the NAV uses closing prices from 3PM — but the ETF will be priced and traded for an additional hour. The divergence in the market price from the NAV in this case is related to the timing difference and not an issue with the ETFs market price.

Example #3: Cash-based Fixed Income ETFs
The final example is specific to active ETFs that operate with cash creations and cash redemptions, similar to most mutual funds. Typically, active ETFs that accept cash will charge authorized participants an additional fee to compensate the fund shareholders when new cash enters the ETF — essentially protecting the current shareholders from transaction costs of incoming buyers. This fee will be reflected in the market price via the spread, but will not be part of the calculation of the NAV.

Understanding the Fixed Income ETF Premium
The examples above highlight reasons that fixed income ETFs will trade a premium under most market conditions. This does not mean that ETFs do not work correctly or are “broken.” It’s simply a reflection of market structure differences between the electronic equity markets and the over-the-counter bond market. Remember, the pricing information for fixed income securities is fragmented while fixed income ETFs trade with real time information. The key benefit to ETF investors is the transaction cost transparency that exists in the ETF structure. Therefore, understanding why a premium or discount exists is crucial in effectively evaluating a fixed income ETF.

 


 

1 An exchange-traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. ETFs trade like common stock on a stock exchange and experience price fluctuations throughout the day as they are bought and sold.

2 The net asset value (NAV) or an exchange traded fund represents the value of each share’s portion of the fund’s underlying assets and cash at the end of the trading day.

3 An exchange traded fund (ETF) that is trading above its net asset value (NAV) is said to be trading at a premium.

4 An exchange traded fund (ETF) that is trading below its net asset value (NAV) is said to be trading at a discount.

RISKS: Exchange-traded funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are not individually redeemable directly with the Fund, and are bought and sold on the secondary market at market price, which may be higher or lower than the ETF's net asset value (NAV). Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active ETFs, unlike typical exchange-traded funds, do not attempt to track or replicate an index. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. There is no assurance that the investment process will consistently lead to successful investing. Fixed income securities / Bonds may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

2085953.2.2