Don't Dismiss Corporate Bond ETFs

Increased spreads and increased volatility have attracted many equity traders to the corporate bond market lately. Traders used to gaining broad exposure to a market or sector through equity ETFs have naturally been drawn to do the same with bond ETFs. Unfortunately, they've also found some pitfalls.

First, take a look at the following graph of the premium (or discount) to net asset value (NAV) for the three largest corporate bond ETFs: iShares iBoxx Investment Grade Corporate Bond (LQD - commentary - Cramer's Take), SPDR Barclays Capital High Yield Bond (JNK - commentary - Cramer's Take), and iShares iBoxx High Yield Corporate Bond (HYG - commentary - Cramer's Take).

Premium/Discount Closing Price vs. Net Asset Value

Those accustomed to following tracking error on equity ETFs probably find this graph quite shocking. Both JNK and HYG have traded with discounts of 8% or more, and premiums of 10% or more. You'd expect LQD to trade tighter, as this fund is focused on the more staid investment-grade segment of the bond market. But even LQD traded at a nearly 11% discount in September.

Whether you are a trader trying to play short-term market moves or a longer-term investor trying to emulate the return of the sector generally, the seemingly erratic trading of these funds may suggest you should dismiss ETFs as a viable means of trading the corporate bond market. In particular, with bond ETFs typically trading at a 1% to 2% premium to NAV, one might conclude that open-end funds are a better option.

Dig deeper before jumping to this conclusion. First, consider why the trading price can deviate so severely from its NAV. There are two major reasons for this. As you can see from the graph above, all three of these ETFs typically trade with a small premium, about 2% on average. This reflects the bid/ask spread of corporate bonds. Remember that corporate bonds are not traded on an exchange, so there is no single "closing price" like there is for stocks. In fact, only a small percentage of corporate bonds actually trade on a given day.

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At the time of publication, Cavanaugh Capital Management had long positions in LQD and PepsiCo 7.9% of 18, although positions may change at any time.

Tom Graff is a managing director of Cavanaugh Capital Management, a registered investment adviser in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.