Loading...
Symbols:
Authors:

Largest Bond ETF Now Trading At a Massive Discount

by: Alan Brochstein October 11, 2008 | about stocks: AGG / BND    

Alan Brochstein

Become a Contributor Submit an Article
  • Font Size:
  • Print

In a world where my average equity holding moves in a 10% daily range, very little should surprise me.  I would like to share with you, however, something that makes absolutely no sense.  The world's largest bond ETF, and one of the largest ETFs overall, iShares Lehman Aggregate Bond Fund (AGG), is trading at an 8.9% discount.

For those not familiar with the ETF, you can visit the iShares website to learn more.  It is designed to replicate the most popular bond index, the Lehman Aggregate.  It has over $9 billion in assets invested in 174 securities that replicate the index.  Total annual expenses are 0.24%. 

In its 5 year history, the NAV has tracked the index precisely (after accounting for expenses).  Normally, the closing market price has been within 0.5% of the NAV since inception.  I had noticed earlier this month some more volatile trading during the day and observed that the discount had widened to about 3% as of 10/09 (not enough to justify giving much thought), but the floor fell out yesterday.  It shows up in the longer-term, since-inception chart below (note that the NAV is 96.99):

(click to enlarge)

AGG 

What is going on?  I believe that several factors could explain why someone is willing to sell something that is worth 97 for 88.4. 

First, note that the ETF made a new all-time low, and this may have engendered some panic selling.  The overall underlying index it tracks has been hurt by its exposure to corporate bonds this year, with only a little offset from the Treasuries.  Through 10/10, the total return of the index is almost -1% (so the "price" return must be close to -6%).  The above chart doesn't reflect that holders of the AGG get monthly income as well. 

Second, many "closed-end" funds are trading at historic discounts, including ones with junk-bonds or munis as the underlying securities in which the funds invest.  This is a time people are selling today for what they can, in fear that they will get less in the future. 

Third, I would imagine that there is, in general, selling pressure by what I believe are the primary holders (and typical buyers) of the AGG, individuals and money managers who run separate accounts.  Perhaps combining all these points, one can conclude that someone has been either forced to sell or is willing to sell in fear that this ETF could move to an even bigger discount.

This makes no sense!  Ultimately, there is an arbitrage here, though it requires one to be willing to do it for a minimum of 100K shares (that would cost almost $9mm).  Additionally, there is a 2% fee for "redemption". 

I confirmed with iShares that this mechanism is currently in effect.  One would receive a portfolio of 174 securities as well.  Given that AGG typically trades 600k shares per day (though 1.5mm yesterday) and that most people aren't set up to receive a basket of securities, it isn't surprising that such an anomaly could occur over a short period of time.

It appears that in the short-term, the number of sellers overwhelmed potential buyers (given the surge in volume).  With professional investors fighting so many fires, I am not surprised that this could slip through the cracks.  They may not be the ones able to take advantage of this fire-sale.  In fact, they may themselves be sellers as they rebalance to correct asset allocations (since stocks have fallen so sharply relative to bonds).

Why shouldn't we expect AGG to trade at a steep discount similar to other "closed-end funds"?  First, unlike the steeply discounted muni and high-yield bond funds, AGG has a redemption process.  Second, the annual fees of just 0.24% as well as the passive nature of the fund preserve more of the underlying asset value.  Third, we aren't seeing this phenomenon in other bond ETFs run by iShares, though it persists at the smaller Vanguard Total Bond Index Fund ETF (BND) to a lesser degree (5%).  Fourth, one would expect that holders of bond mutual funds (even a large passive one at Vanguard) would consider selling out to buy this.  After all, while I expect the gap should close quickly, even if it took 3 years, very few actively managed funds would be able to return index + 3%.  Finally, this must be an embarassment to Barclays, which runs iShares.  They have a large vested interest in making sure that investors don't come to view ETFs as having this type of NAV discount risk.

This is an opportunity certainly for longer-term fixed-income investors (buying "the market" at a large discount), but it is certainly potentially an opportunity for a trader.  Yes, in this crazy market, an anomaly that might ordinarily not persist for long could end up taking a while to reverse, but this one, given the redemption process, seems unlikely to endure.

Disclosure:  Long AGG

Related Articles

This article has 39 comments:

  •  
    Oct 11 04:33 PM
    I got out at $97...had moved $ into AGG for safety, only to see it steadily drop. Good thing I got out and went to cash.
    Reply
  •  
    Oct 11 05:43 PM
    Top Cat, you were definitely on top of it.. I'm out at $88, one of the bigger losses for the year in what I thought was a pretty safe place to be parked.
    Reply
  •  
    Oct 11 06:28 PM
    I'm surprised that the author did not review the conditions under which a bond fund would drop in value. Just like the brokers that sell municipal bonds to retirees, baiting them with tax advantages and interest rates, they imply that bonds do not lose their face value. Everything can lose value, and this article's failure to review that undermines the author's assertion.
    Reply
  •  
    Oct 11 06:33 PM
    From a typical bond fund disclaimer:

    "Risks include interest-rate risk, market risk, credit risk, foreign security risk, and prepayment risk. A decrease in interest rates usually causes an increase in value of bonds. An increase, or the expectation of an increase in interest rates generally causes a decrease in the value of bonds."

    I'm sure there are other bond funds that depend on other specific conditions. Anyone wish to add to this thread?
    Reply
  •  
    Oct 11 07:03 PM
    BxCapricorn, my point isn't that it could drop in value. Did you read the article? The market price is substantially below the intrinsic value of the underlying assets despite the fact that there is a mechanism to keep it roughly in line via the Redemption process (page 4 of the prospectus). In a former life, I was a professional bond-trader - I understand that the underlying assets can change in value.
    Reply
  •  
    Oct 11 07:27 PM
    This is an interesting article - it will be interesting to see how it develops. We are seeing a few oddities in the ETF market, but this is one of the most surprising. Have you talked to anyone at IndexUniverse about this?

    Thanks, and keep us informed!
    Reply
  •  
    Oct 11 07:30 PM
    I believe AB is pointing out that the ETF is at a discount to the total value of the 174 bonds in the index. Each of the 174 would of course have the exposure you identify, but the article concerns "tracking error" which seems to be more prevalent in ETF's given reason volatility, especially in commodities.
    Same thing as a closed end fund
    Reply
  •  
    Oct 11 07:35 PM
    Pretty cool, though how to perform arbitrage in a violent market like on Friday, where ups and downs occurred in minutes (especially with the US Govt Plunge Protection Team working) is beyond me. Maybe if you have a proprietary seat on some exchange it could work.
    Reply
  •  
    Oct 11 07:58 PM
    Brian, I have spoken only to my institutional clients and directly to an iShares representative. He informed me that they had received a ton of calls. If I understand the dynamics correctly, this won't persist for long. As I wrote above, though, lots of fires to put out, this one isn't the most pressing. Theoretically, though, for those who don't understand my point, someone with $8.5 billion dollars could buy the whole fund and turn around and exchange it for $9.4 billion (i.e make almost $1 billion, less the 2% fee).
    Reply
  •  
    Oct 11 08:13 PM
    problem is you couldnt sell the $9.4 Billion at anywhere near that number if your life depended on it. There is a shortage of buyers and just because the last quoted trade was at that price doesnt mean you coulg get that price if you showed up with size to sell
    Reply
  •  
    Oct 11 08:16 PM
    Alan, did you see the Corp bond mkt on Fri?? Our corp trader was buying A and AA credits (non financial) at 8-12%. Check TRACE on some of the bonds held in the Trust and see if the disco is real.
    Reply
  •  
    Oct 11 09:38 PM
    Alan, let me summarize the impetus for this discount as I've come to understand it:
    ETFs occasionally unhinge from the value of their underlying assets when there's crowding-in/out. This happens for 2 reasons...
    1) The imbalance of buyers & sellers of the physical ETF shares in the open market creates wider bid/ask spreads
    2) Even larger imbalances of buyers & sellers force ETF reps to redeem or purchase proportional chunks of the underlying portfolio in order to maintain a liquid market in the tracking ETF shares? To redeem, for example, reps purchase ETF shares on the open market, pass them thru to the custodian--who holds the stock certs or bonds for the underlying portfolio. The custodian exchanges those ETF shares for the corresponding basket of stock/bonds, which the rep must flip on the open market.
    Authorized reps are motivated by arbitrage, because they can purchase ETF shares at a discount, then sell the basket at market price. This happens to mutually benefit ETF shareholders because it keeps share supply/demand (bid&ask) in balance and therefore in line with NAV.
    This tells me that there's illiquidity in the market for the underlying basket of securities, hence iShares reps cannot flip the underlying bonds on the open market, meaning they can't redeem ETF shares to rebalance supply to meet waning demand (as sellers are overwhelming buyers).
    Reply
  •  
    Oct 11 09:40 PM
    Halfempty, it wasn't just the "last quoted price". There was selling pressure all day. As I mentioned in the article, 1.5mm shares traded ($140 mm) compared to the normal 600k.

    Alex_G, you do raise a good point, but the discount seems then it would be greater on a pure corporate bond ETF than one that includes a lot more MBS and Treasury securities. CFT, which is a rather small ETF, closed at 77 compared to an NAV of 86 (slightly wider). That one is 100% corporate bonds compared to AGG being just 20% or so. I appreciate your observation, though - that NAV could be somewhat suspect.
    Reply
  •  
    Oct 11 09:40 PM
    Author hit on answer and then ignored it. Professionals who would normally arbitrage out the discount have much bigger problems on their hands: survival. Amateur investors can buy similar CEFs at 30% discounts.
    Reply
  •  
    Oct 11 09:46 PM
    CMA CMA, I don't believe I ignored it at all. I believe that due to market conditions, this situation may persist somewhat longer than one might normally assume. I am unaware of a large passive ETF with open redemption/creation trading anywhere near this kind of discount. As I acknowledged in the article, there are lots of really cheap closed-end funds, but there isn't a mechanism to arbitrage the differences. An investor is subject to high fees (on the NAV, by the way) as well as potential mismangement by the active manager. I am not trying to make a judgment - they are probably both ultimately great buys. AGG is just a safer one.
    Reply
  •  
    Oct 11 10:12 PM
    ...Building on that conclusion, you would expect that either shares will be redeemed throughout Monday 10/13 OR buyers will crowd-in to take advantage of the arbitrage. The risk is as follows:
    10% of the fund's assets can be invested in assets not included in the Lehman US Aggregate Bond Index including other bonds and high-quality Barclay's MMFs. If the fund's assets are leveraged, the loss in value of some/all of these ancillary 10% assets would be magnified to reduce NAV by marginally more than their percent contribution to the portfolio.
    Reply
  •  
    Oct 11 10:14 PM
    could it have anything to do with the Lehman sponsorship ?
    Reply
  •  
    Oct 11 10:26 PM
    Look at the table, lifted from iShares, showing the make-up of AGG. Perhaps the FNMA, GNMA, and FHL bonds' pricing doesn't reflect all of the risks that these securities may carry.
    Top Sectors as of 10/9/2008 Trading Information
    25.50% U.S. Treasury
    17.57% FHLMC
    16.84% FNMA
    11.68% US Agencies
    9.62% Financial Institutions
    8.40% Industrial
    3.91% Non-Corporate
    3.59% GNMA
    1.93% Utility
    0.35% S-T Securities
    Related Index N/A
    NAV Per Share AGG.NV
    Und. Trading Value AGG.IV
    Shares Outstanding AGG.SO
    Est. Cash AGG.EU
    Total Cash AGG.TC
    CUSIP 464287226
    Options Available
    Reply
  •  
    Oct 11 10:50 PM
    manyathought: that is one of the reasons I got out...I thought maybe the "Lehman" name was scaring away the smaller investor who did not know better.
    Reply
  •  
    Oct 11 11:05 PM
    you guys are funny , it has NOTHING to do with Lehman ! I shares pays a small fee for using a Lehman trademarked index . It has nothing to do w/ Lehman . What Alan is trying to say is [ I think ] is that we are seeing a severe credit crunch which will be a great trading or investing opp. I like the article , if you already owned it , well that sucks . I would not sell , probaly add a little to my position . People who sell in fear create great investing and trading opp. for savvy people .
    Reply
  •  
    Oct 11 11:11 PM
    Alan,

    I think you are mistaking a floor for the trap door. The lifeline you're reaching for -- it's a noose.
    Reply
  •  
    Oct 12 12:03 AM
    Even though its at a "massive" discount, why couldn't you short this fund and buy an equivalent amount (based on NAV) of discounted closed-end funds (assuming you could approximate the same bond holdings). There are many closed-end bond funds selling at a similarly "massive" historic discount of 40-50% of NAV. So you would be market neutral, but get the difference in the discounts up front. This seems like an instant 35%-40% profit -- Am I missing something?
    Reply
  •  
    Oct 12 12:05 AM
    Curbs-In,
    Please explain?
    Mr. Brochstein has identified a reasonable arbitrage opp. If AGG (the ETF, not its underlying portfolio) is pricing as a forward indicator (so to say that the portfolio's securities have yet to reflect some present or future credit/interest risk), there may be a "trap door," but given its severe discount to NAV, a cushion for downside risk is conveniently priced in for us.
    There're extraneous factors at work here, like an inability of iShares' authorized reps to redeem shares because they cannot sell-off the underlying securities due to bond market illiquidity --OR-- the unmanageable volumes of redemptions required.

    berberich,
    See the following. IT MAY BE THE EXTRANEOUS FACTOR THAT THIS ARTICLE IS LOOKING FOR...
    www.indexuniverse.com/...

    On Oct 11 11:11 PM Curbs-In wrote:

    > Alan,
    >
    > I think you are mistaking a floor for the trap door. The lifeline
    > you're reaching for -- it's a noose.
    Reply
  •  
    Oct 12 12:11 AM
    Yes, I understand you have to pay short interest, closed end fund management fees, the shorted funds dividends. But when/if the discount difference narrows, you could begin to close out your position. Meanwhile perhaps the "profit" you make up front will be put to good use. And if the discount difference increases? Well we all make mistakes. How high can the discount go? At some point the closed end fund manager should figure out a way to buy up shares.
    Reply
  •  
    Oct 12 12:17 AM
    *Sounds like there would be expensive rebalancing liabilities for the ETF if the Bond Index is outsourced to a third party by SEC mandate. The alternative would be (in the Wisdom Tree case) simultaneous reporting of AGG portfolio changes and changes to the LEH US Agg Bond Index. Such reporting would increase the management costs of the AGG ETF.
    Reply
  •  
    Oct 12 12:30 AM
    hardball 22, first, I would expect an exemption. Second, the 14 funds could be sold to someone else if necessary. Third, how much higher do you think the expenses would be? The fund has $9 billion in assets. It seems like the cost if even $1mm is rather trivial (it's late here in Texas, but that is about 1 bps). Why then aren't the other 13 funds trading at a big discount? This fund is a tuna fish and the other 13 are minnows. If this argument were true, the other funds would be reflecting the poor future economics even more. It's simply not an issue.

    I think that I have identified in the original article almost all of the underlying factors. I appreciate those of you who shared your opinions, as I learned that I omitted one factor: Bid-offer spreads have widened significantly, which contributes to some uncertainty regarding the true value of the NAV. Remember, though, that the illiquid bonds are primarily the pure corporate bonds, and they represent about 20% of the portfolio. Let's say that they are off by 10% - this would account for just 2% of the discount.
    Reply
  •  
    Oct 12 12:34 AM
    It seems this situation is a danger for ETFs (of all sorts) when they are very large. It could take very deep pockets for management to deal with extreme unbalances on either the buy or sell side. It sort of assumes a well-behaved market of the underlying assets.
    Reply
  •  
    Oct 12 12:37 AM
    Robert_A,

    First, some of the closed-end funds surely could prove to be fantastic investments. Remember, though, that their managers get paid on the NAV, not the stock price. They have a disincentive to reduce the size of the ETF - it costs them money (i.e tendering for shares on the open market). I don't follow that market so closely, but I recall a lot of shareholder suits in the past.

    As far as buying the super-duper cheap closed-end funds and shorting the merely heavily discounted ETF seems foolish to me. Recall that the fees are much higher (over 5X, on an annual basis) for what you would be buying. Additionally, you are subject to active manager performance. Perhaps most importantly, you are assuming a great deal of risk known as "basis risk": You are short Treasuries, mortgages and investment-grade corporate bonds to go long either municipal bonds or junk bonds. I am not trying to make a "value" call on your proposed trade but rather point out some reasons that it isn't the lay-up that you perceive. I have friends and clients who have been buying the 30% discounted funds. Of course, they were buying them when they were at 15% too.
    Reply
  •  
    Oct 12 12:47 AM
    ahh, I knew there was a catch, there's always a catch. Now I know why closed end fund discounts get so extreme -- the fund managers aren't working for the shareholders, only for themselves.
    Reply
  •  
    Oct 12 12:48 AM
    Half empty: You could always sell to the USTreasury bailout fund.

    BORROW $8.5 Billion, buy the ETF, then claim you are underwater and need 'saving'. Sell to the FED at $9.4 Billion, repay loan.

    Retire.
    Reply
  •  
    Oct 12 12:57 AM
    Seems like you gotta put a pretty serious discount to account for potential defaults on the 17% that's financials and industrials no?
    Reply
  •  
    Oct 12 12:32 PM
    Surely, those interested enough to own the security understand the Lehman 'connection'. The author isn't soliciting an arbitrage, merely pointing out that a mechanism to 'enforce' NAV exists and that it significantly distinguishes this security from any 'similarly' constituted CEF.
    Reply
  •  
    Oct 12 03:50 PM
    Thanks for all the fish. and you deserve accolades for answering comments in such a timely, well-written manner.
    Reply
  •  
    Oct 12 05:30 PM
    Is it possible that the prices being used determine the NAV are implicitly being questioned by traders. If some sectors are trading with large bid/offer spreads or are not trading the prices being used may not reflect where one could hedge to exploit the "arbitrage".
    Reply
  •  
    Oct 12 05:44 PM
    I think your point is well taken, as some of the comments have adressed the issue. I do believe that a certain amount of NAV question discount should exist after considering the point. If the Corporate bonds are off by 10%, that would imply about a 2% total discrepancy. I don't know exactly how wide the spreads are on the "safer" securities that represent the remaining 80%. Still, though, consider this. If you own the Vanguard Total Bond Market Fund ETF (BND), I believe it is part of a larger underlying pool of assets that is offered as a mutual fund. If this persists, it would be almost riskless to sell the mutual fund (at the 4pm price) and buy the ETF at the 4pm close. My point isn't really that one should arbitrage this but rather suggest that this is a relatively cheap way to buy exposure to the broad bond market in a highly liquid and low cost manner. Some others have suggested that they would rather go after traditional closed-end funds at off-the-charts discounts of 30% or so, and I can't argue with that strategy in the long-run (though it is riskier and more expensive over time if the gap doesn't close quickly). Your acronym suggests that you might be able to tell me how wide the bid/offer is on Agency mortgages in the TBA market. Care to share?
    Reply
  •  
    Oct 13 01:00 AM
    It looks like it is liquidity risk being priced into the underlying bonds that are frozen right now...

    All explained here folks

    www.indexuniverse.com/...

    "Bond ETFs Taking Divergent Paths In Murky Markets"

    Matthew Tucker is head of investment strategy for fixed income at Barclays Global Investors in San Francisco. IndexUniverse.com caught up with the busy bond executive on Thursday to find out how the ongoing credit crunch is impacting iShares' exchange-traded funds focusing on fixed-income markets.
    Reply
  •  
    Oct 15 02:51 PM
    Re: Trap Door

    Time has sorted this out itseems, though I suspect you expect to see a recurrence..., and more hangings
    Reply
  •  
    Oct 15 05:44 PM
    I'm holding BND and I'm considering selling and then buying AGG or a similar fund. I know they're both irrationally discounted and affected by panic selling, but this way I would get to harvest tax losses - which is the one thing in this market I can do to guarantee some kind of return! I'll enjoy reversion to the mean later.
    Reply
  •  
    Oct 15 06:41 PM
    That makes sense, Chris B - they are pretty close to the same thing. I don't believe that the discount is so great on AGG any longer, though it is somewhat below the NAV.
    Reply