Amid lots of media focus on bond ETFs and discounts, Tabula CIO Jason Smith looks at different approaches to ETF construction to see if some ETFs are more susceptible than others.

 Key Takeaways

 - Discounts in bond ETFs can result from stale benchmark prices

 - Some large and well-managed bond ETFs are hampered by the indices they choose to track

 - ETFs that track liquidity-focused indices may trade closer to NAV in a crisis

 - When central banks intervene, it’s the large, liquid bonds they tend to buy and the more liquidity-focused ETFs that stand to benefit

It’s “not supposed to happen” but it does

ETFs are known for their accurate index tracking. However, in extreme market conditions, as we saw in March 2020, some bond ETFs trade at a discount to their Net Asset Value (NAV). A Financial Times report on 30 March 2020 entitled “Price gap triggers fears for bond ETFs” highlighted ETFs trading at discounts of over 6%.

ETF providers may argue that this is not so much a discount as price discovery. Since some bonds trade infrequently, the prices used to calculate an ETF’s NAV could be quite stale. In contrast, an ETF trading on exchange gives a realistic snapshot of current market prices. Although this argument makes sense, it can still be frustrating for investors to see a large dislocation between trading prices and NAVs, especially at times of market stress when the simplicity and transparency of ETFs could be particularly beneficial.

Are indices the elephants in the room?

The large bond ETFs behind the March headlines tend to have two things in common. Firstly, they are well managed by providers with deservedly good reputations in the ETF market. Secondly, they are tracking traditional, market capitalisation-weighted bond indices. Could these indices be the problem?

Many traditional bond indices pre-date ETFs. They were designed to provide comprehensive representations of the whole bond market. Since a single corporation may have multiple issues and many outstanding bonds, the indices and the ETFs that track them, have many thousands of constituents. For example, the Bloomberg Barclays Euro Corporate Bond Index has around 2800 constituents. The four largest ETFs tracking this index – managed by iShares, X-Tracker, State Street and Vanguard – are holding between 2200 and 3000 different bonds. Market capitalisation weighting means that some of these holdings are very small. Compare that to European equities, where the largest ETFs track MSCI Europe (around 400 companies) and the EURO STOXX 50.

In normal market conditions, these large bond ETFs trade very close to NAV. However, even with the best sampling and optimisation methodologies, the indices which the ETFs track were never designed to be tradeable. In times of market stress, when there may be large outflows, the design flaws show. Market makers are forced to make prices for bonds that rarely trade, official prices don’t always reflect the live market and discounts are inevitable.

A new approach to indexation can offer investor benefits

Indexation is a challenge for fixed income, but not an insurmountable one. Clearly bond markets are more complex than equity markets. However, the success of EURO STOXX 50 suggests that benchmarks can be representative even if they reflect only the larger, more liquid securities.

Perhaps an updated view of the “market” is needed too. For corporate bonds in particular, much of the buying and selling of risk now happens in the credit default swap (CDS) market rather than by trading physical bonds. CDS indices like iTraxx Europe see significant trading volume and could be said to reflect the European corporate credit market as much as any bond index.

The new iBoxx iTraxx Europe Bond Index incorporates both these ideas. It focuses on larger, more liquid securities and looks to the credit market to help select them. Most importantly, this index is designed to be traded, with liquidity as a priority at every step of index construction.

Effectively, the index is a bond version of the iTraxx Europe, which comprises 125 investment grade entities, selected on the basis of liquidity. It includes up to three bonds per issuer and, as of April 2020, had around 260 constituents, a fraction of the number in a traditionally-constructed benchmark. The other key difference is weighting. Like iTraxx Europe, the index weights issuers equally and has fixed ranges for sectors. In this way, it avoids an overweight allocation to the most indebted issuers and sectors.

iBoxx iTraxx Europe Bond Index
Bloomberg Barclays Euro Corporate Bond Index
~260 (up to 3 bonds for each of the 125 entities in iTraxx Europe)
Market coverage
European issuers of EUR-denominated bonds
All EUR-denominated bonds (typically ~ 20% US issuers)
Liquidity filter
Min 500M outstanding
Min 300M outstanding
Equal notional per issuer
Market capitalisation
Average duration
5Y target maturity
Typically ~ 5Y but wide range of maturities from 1y to  > 15y

Spot the difference

How do the different approaches to index construction translate to ETF liquidity? Here, we compare two ETFs. Europe’s largest investment grade bond ETF, iShares Core € Corporate Bond UCITS ETF (IEAC) tracks the Bloomberg Barclays Euro Corporate Bond Index and typically holds around 2800 bonds. Tabula iTraxx IG Bond UCITS ETF (TTRX) tracks the iBoxx iTraxx Europe Bond Index described above and holds around 230 bonds. The charts show the liquidity of the bonds held by the two ETFs according to two different liquidity metrics:

Amount outstanding – a crude but widely used measure, with EUR 500m often viewed as a threshold for good liquidity
Bloomberg Liquidity Score – a more sophisticated measure with multiple inputs, aiming to reflect the likely time and cost to execute

By virtue of its index construction, TTRX is able to avoid holding any bonds with less than EUR 500m outstanding or with a liquidity score below 50 (swipe below to compare).

Data: Tabula, ETF provider websites, Bloomberg, as of 3 April 2020

What does this mean for discounts?

Discounts in bond ETFs peaked on 19 March 2020. As the chart shows, IEAC’s closing price was over 6% below NAV, while TTRX’s discount was only 3.9%. TTRX is still vulnerable to discounts but typically of a far smaller magnitude.

Data: Tabula/LSE, 21 February 2020 to 20 March 2020.

Note that ETFs tracking CDS indices rather than physical bonds were able to avoid discounts altogether – click here to see our full range.

Where would you rather be in a crisis?

Bond ETFs have been transformational, providing significant benefits to many investors and acting as a source of liquidity. However, in a crisis, even the biggest and best may come under pressure. In our view, the use of unsuitable and outdated benchmarks is the main issue. Investors now have the option to choose new benchmarks that better reflect the modern fixed income market and its trading activity and, as a result, can be more resilient in a liquidity crunch.

Finally, it is worth noting that crises often go hand-in-hand with central bank intervention. In the current crisis, the ECB has announced its intention to buy corporate bonds and it’s no surprise that it is focusing on the larger, more liquid issues. Over 50% of TTRX’s assets are on the ECB list, compared to only 31% of IEAC’s, making TTRX potentially well placed to benefit more from the intervention.


Jason Smith, Chief Investment Officer