Quantifying corporate bond ETF premiums and discounts
By David Krein and John Keller | 4 May 2020
Highlights
- Bond ETFs traded at a premium or discount to their “fair” value, measured by the bid/offer levels of their underlying bonds, throughout recent credit market volatility.
- On April 9th, when the Federal Reserve expanded their QE program to include High Yield bonds, ETF share prices traded at a premium to their underlying holdings.
- The Open Trading™ marketplace allowed participants to connect and take advantage of this arbitrage opportunity.
Arbitrage opportunities
Under typical market conditions, corporate bond ETF share prices lie in or around the fair value of their underlying bonds, calculated using Composite+™ bid/offers. However, under recent extreme conditions, ETF share prices have moved outside the NAVs, i.e. fair value, of their underlying securities.
US IG corporate bond ETF, LQD, share price ($) vs Composite+ NAV on April 9th
US HY corporate bond ETF, HYG, share price ($) vs Composite+ NAV on April 9th
The most pronounced example of this was on April 9th, when the Federal Reserve announced an additional $2.3 trillion to its QE program, including High Yield bonds and Junk ETFs. A global market rally ensued where arbitrage opportunities emerged in Bond ETFs. The US IG corporate bond index, LQD, traded at a $1.45-$3.62 premium to the NAV of the underlying bonds, while the US HY corporate bond index, HYG, traded at a $2.3-$6.55 premium throughout the day.
More recently, on April 21st, corporate bond ETFs were trading at a discount to their fair value as oil turned negative for the first time in its history, leading to a global market sell-off. The US IG and HY ETFs, LQD and HYG, traded at discounts of as much as 60 cents and 109 cents, respectively, versus the “fair” value measured by Composite+ bid/offer levels.
Connecting participants to engage liquidity
Arbitrage opportunities remain within ETF markets as volatility persists and underlying credit market spreads remain elevated. During recent volatility, we observed that ETF participants, as well asset managers and other non-bank institutions, were an active part of the liquidity transfer mechanism [see: “AxessPoint: Diverse participants create liquidity opportunities during credit market stress”]. The diverse trading connections facilitated by Open Trading allowed participants to take advantage of this arbitrage opportunity and maximize their liquidity options.
Redefining real-time bond ETF pricing
Composite+ is MarketAxess’ proprietary AI-powered pricing engine for corporate bonds. It produces an unbiased, two-sided market for more than 25,000 instruments globally. Updated every 15 to 60 seconds, the engine generates nearly 20 million levels per day covering 90-95% of trading activity in its markets.
Through MarketAxess’ partnership with Virtu, the upcoming eNAV data service will provide real-time NAVs for corporate bond ETF markets, powered by Composite+. This will measure ETF “fair” value, in real-time, previously unavailable in the marketplace.
For questions or follow-up, email our data scientists at [email protected].