How do bond ETFs behave when markets are extreme?

July 7, 2020

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Bond ETF premiums and discounts: Analyzing market price and NAV behavior from the financial crisis to COVID-19

ETF investors in March experienced some of the largest discounts seen across bond ETFs since the global financial crisis. A few Vanguard fixed income ETFs showed uncharacteristically large deviations, with two posting discounts greater than 7% on a given day. These discounts have drawn the attention of insurers and other institutional investors who use bond ETFs to gain targeted exposure to fixed income markets, employ tactical tilts, and minimize cash drag, among other applications.

Vanguard fixed income ETFs: Highest premiums and discounts during GFC and COVID-19

Vanguard fixed income ETFs: Highest premiums and discounts during GFC and COVID-19

Notes: The global financial crisis (GFC) period cited in the table refers to the trading days of June 2, 2008, through March 31, 2009. The COVID-19 pandemic period refers to the trading days of February 3, 2020, through March 27, 2020. The table shows both the range and the average of premiums and discounts experienced by Vanguard bond ETFs during those periods.
Source: Vanguard calculations, based on data from Bloomberg. Past performance is no guarantee of future results.

Importantly, these premiums or discounts are "perceived." That is, the end-of-day premium or discount doesn't fully reflect what investors experience throughout the day. Take, for example, Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which closed on March 11, 2020, at a perceived discount of 2.20% (closing price of $89.50 and NAV of $91.50), whereas throughout the day it ranged from a premium of 0.60% to a discount of 2.04%, averaging a discount of 1.25%.

Although the global financial crisis and the COVID-19 pandemic differ starkly, both periods exhibited significantly diminished liquidity across financial markets.

This note adds to the discussion about market price and NAV by offering a lens into how the two pricing mechanisms behave when extreme premiums and discounts close.

Volatility of an ETF's market price versus its NAV

Discounts of the magnitude we've recently seen have few precedents. We must look back to the financial crisis for comparable examples. ETF market prices tend to be more volatile than their NAVs. Specifically, the cumulative magnitude of changes in market price during periods of stress eclipses that of the NAV when the two begin to converge or return to a "normal" range. This seems to support one narrative that ETFs serve a vital price-discovery role, delivering real-time information about their underlying constituents as market makers adjust for changing transaction costs.

The last time we saw similar-sized deviations in market price and NAV was during the global financial crisis

Vanguard Total Bond Market ETF (BND) premiums/discounts

Vanguard Total Bond Market ETF (BND) premiums/discounts

Note: The figure shows the premiums and discounts of Vanguard Total Bond Market ETF from April 10, 2007, through March 27, 2020. The arrows point to periods in which significant deviations in market price and NAV coincided with large market liquidity crunches. Past performance is no guarantee of future results.

Two observations from the GFC

BND market price and net asset value
Extreme premiums/discounts cluster during periods of extreme volatility and dissipate quickly afterward

BND market price and net asset value

Note: The figure illustrates the relationship between market volatility, represented by the VIX, and the difference between market price and NAV. Data cover the period from June 2, 2008, through December 31, 2008. Past performance is no guarantee of future results.

BND 5-day rolling average daily volume (shares)
Despite diminished liquidity, trading volumes are elevated

BND 5-day rolling average daily volume (shares)

Note: The figure shows the 5-day rolling average daily volumes for BND from June 2, 2008, through December 31, 2008.
Source: Vanguard calculations, based on data from Bloomberg.

Results are mixed as to which price is in the driver's seat during gap closures

Although market price appears to display larger relative price adjustments than NAV, results are mixed as to which price accounts for "closing the gap." During the financial crisis, on days following extreme premiums or discounts (measured here by a hard +/–2% to NAV), market price outstripped NAV 73% of the time.¹ But fast-forward to March 2020—our most recent monthly period of severe market dislocation—and both NAV and market price drove convergence roughly 50% of the time.²

These observations reinforce two notions:

  1. An ETF's market price decouples from its net asset value, and investors can expect this to recur for reasons we've cited before: differences in valuation estimates, supply and demand for the ETF, and the cost of accessing liquidity for an underlying market in which liquidity has significantly contracted.
  2. If possible, avoid trading at the start and the end of a trading day and consider using limit orders. However, during periods of elevated market volatility, the best approach may be to avoid trading altogether.

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Extreme premium and discount trading days account for a small portion of the totals

Extreme premium and discount trading days account for a small portion of the totals

Notes: The table shows available trading days for the listed ETFs since their inceptions. The number on the right side of each bar indicates the times when the ETF traded at a premium or discount larger than 2%. The trading dates begin as early as April 10, 2007 (the start dates vary for each ETF), and run through March 27, 2020.
Source: Vanguard calculations, based on data from Bloomberg.


¹ Observations are restricted to BND, BSV, BIV, BLV, and EDV, as these were the only Vanguard bond ETFs with data that go back to the global financial crisis. A total of 52 observations exceeded +/–2%. "Closing the gap" refers to the point when the difference between market price and NAV comes back within the 2% band and can be interpreted as returning to a "less extreme" state.
² Observations include all 18 available Vanguard fixed income ETFs. A total of 57 observations exceeded +/–2%.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. Investments in bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • Vanguard ETF® Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.