Largest Bond ETF Trades at Massive Discount
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 a 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):
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 whom 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 less degree (5%). Third, 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, who 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
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