Aussie exchange traded funds that buy the debts of companies and governments – called bonds – have hit a major snag this week.

As coronavirus panic has sent markets into turbulence, popular bond ETFs have started trading at prices below their fair value, known as discounts.

Some ETFs are trading at discounts 10% beneath the fund’s value. The discounts have caught some advisors who use bond ETFs by surprise.

ASX Ticker

Fund Name

Discount

PLUS

VanEck Vectors Australian Corporate Bond Plus ETF

-9.75%

CRED

BetaShares Australian Investment Grade Corporate Bond ETF

-3.46%

VACF

Vanguard Australian Corporate Fixed Interest Index ETF

-3.11%

Source: Bloomberg, discounts at 17 March

“Volatility in credit markets has increased and naturally affecting the exposures these ETFs hold,” Kyle Frost, an advisor with Millennial Independent Advice, said.

“But I have been surprised and concerned with the size of the market movements on ETFs that are relatively low risk given the low duration and relatively high credit quality of issuers."

Discounts are common on other types of investment fund, such as listed investment companies and trusts (LICs and LITs). But ETFs have been advertised as superior to these competitor fund types, on the grounds that they suffer discounts less – if at all.

ETFs usually have a fail-safe that allows traders to remove discounts. This fail-safe lets traders buy up the cheap ETFs (i.e. buy low) and sell the bonds that ETFs hold (i.e. sell high), locking in a risk-free profit until the ETF and its bonds trade at the same price.

But when markets are rocky this fail-safe can break down.

This reason this fail-safe can break down is that bonds do not trade on public exchanges – like the ASX – in the way shares do. Instead, they are traded directly between institutions and rely on a core group of banks to do most of the trading.

When volatility picks up, these banks can decide to lie low and ask investors to pay them more in order to trade – much like a ship captain will charge seafarers more to sail in a cyclone. This can mean that bond trading becomes more expensive until things calm down and removing ETF discounts becomes too expensive.

The discounts can confuse – and sometimes annoy – investors, who buy into bond ETFs hoping they will tightly track their index. They can annoy investors more when they arrive exactly at the moment they hope bond funds will act as safe-havens.

According to a Vanguard spokesperson, these discounts tend to be short-lived and investors with a longer time horizon will be unaffected.

“ETF pricing during periods of extreme market volatility may involve…pricing dislocation as the valuations on [bonds] are changing rapidly…This is a short term influence…[and] there is no indication that this is a significant issue for investors with a sound investment strategy in place across a suitable time frame,” they said.

Panic sell off shows the limits of junk bond ETFs

Potentially complicating the matter is that ETF providers deal with discounts differently. How they deal with them involves helping some kinds of investors more than others.

Some ETF providers have chosen to help traders who try to close the discount. This is done by giving traders an exit price close to the index price, despite it being unavailable in the bond market.

This has the benefit of helping investors who want to exit. However, it can be regarded as a kind of subsidy paid by the fund, and ultimately the investors who stay invested.

Other ETF providers have chosen not to provide this kind of help to traders. This means the funds can trade on wider discounts and investors who exit pay, in effect, a liquidity premium.

To some advisors, however, any bond ETF discounts represent a buying opportunity.

“The move to dry powder (cash) has caused liquidity issues at the lesser end of the curve, risk that market makers and counterparties do not want to absorb,” Adam Lawrance, director of Lawrance & Co., a Canberra-based financial advisor, said.

“It does open significant value for those investors happy to invest in diversified debt instruments, perhaps reducing risk for those hybrid/preference shareholders substantially exposed to recent and loose hybrid issuances or for those who are tired of equity market gyrations.”