Welcome to the second installment of our Master Class on bond
ETFs, where we go beyond the basics to learn how these funds work
and gain an understanding of their features and benefits.
Last time, we talked about the
three key elements of a bond ETF
. Now that we've laid the foundation, the next concept to
tackle is how they compare to stock ETFs.
Stock ETFs and bond ETFs actually have quite a few things in
common. Both vehicles typically track an index, both trade
on an equity exchange, and both give investors exposure to a
diversified portfolio of securities in one trade. However,
because stocks and bonds trade very differently, it stands to
reason that stock and bond ETFs would differ as well. In
particular, it's helpful to keep the following things in
trade on an exchange
prices are publicly available throughout the
. There is generally an
active secondary market
for most stocks, meaning that
buyers can typically finds sellers
sellers can typically find buyers
. Everyone in the market can
see at what price they can buy or sell a stock
at a given point in time.
trade over-the-counter (OTC)
prices are negotiated privately between buyers and
. It can be hard for an investor to
find the bonds that they want to buy
, and it can be difficult to
get a price on bonds they want to sell
. It also can be difficult to
find information on where bonds are trading
in order to get a sense of what a fair buy or sell price should
So how do these differences affect bond and stock ETFs?
The impact can be seen in two big ways:
How they are managed.
An ETF portfolio manager (
)'s number one goal is to track the performance of the fund's
target index as closely as possible. The difficulty of this
task can vary greatly depending on how accessible the securities
in the index are. For example, it's relatively easy to
trade the large cap stocks in the S&P 500 Index, whereas it's
harder to trade the less liquid stocks in the MSCI Frontier
Tracking a bond index adds another layer of complexity.
Some bond indexes are huge - think hundreds or even thousands of
bonds. And since bonds are typically less liquid, it's
usually impossible for an ETF to own every security in a given
index - most of those bonds are simply unavailable.
Instead, bond ETF managers use a "sampling" approach where they
try to replicate the risk and return characteristics of the index
using a smaller portfolio of available bonds.
Tracking a bond index can be a challenge, particularly in a
highly illiquid sector such as high yield. The PM of the
ETF is constantly working to reduce portfolio tracking error vs.
the fund's index. And since reputable ETF providers
leverage economies of scale and bond desk relationships in order
to facilitate trades in illiquid securities, investors actually
get exposure to a wider variety of bonds than they would be able
to access on their own. Basically, the bond ETF does the
legwork of tracking down the bond and ensuring a fair price
How they calculate underlying value.
Another key difference between bond ETFs and equity ETFs
is the way that they calculate underlying value. Since
stocks trade on an exchange, the public can see each stock's
current price at any point during market hours, as well as a
closing price at market close. ETF providers use stocks'
prices to calculate an ETF's intraday underlying value throughout
the trading day, and the closing net asset value (
) of an equity ETF is typically very close to the ETF's closing
Bonds trade OTC, and there's typically no central market where
investors can see where bonds were bought and sold. At the
same time the majority of bonds do not trade every day and so
their value must be estimated based upon available market
information. This means that the calculation of a bond ETF's
underlying value is going to be less precise than a stock ETF's
underlying value. As a result, bond ETFs tend to experience
more premiums and discounts, or deviation between the closing ETF
price and the closing NAV.
But while an ETF's NAV is the
estimate of that fund's underlying value,
it's still just an estimate
- especially for bonds. It's not an actionable price that
investors can use to transact a portfolio of underlying
securities. The reality is that market price of a bond ETF
represents the price at which the underlying bonds can actually
be traded at any given moment. Often when we talk about how
innovative bond ETFs are, this is what we're referring to - the
bond market simply didn't have this kind of price transparency
before bond ETFs came along.
Matt Tucker, CFA, is the iShares Head of Fixed Income
Strategy and a regular contributor to
. You can find more of his posts
Stock and bond ETFs both offer benefits to investors, but what
makes the latter category so unique is the fact that it brings
bonds out of the darkness of the OTC market and into the light of
the exchange market. Instead of dealing with a clunky,
opaque trading environment, investors can now access bonds in a
way they've come to expect from stock trading - with price
transparency, relative liquidity, and ease of use.
Bonds and bond funds will decrease in value as interest rates
rise and are subject to credit risk, which refers to the
possibility that the debt issuers may not be able to make
principal and interest payments or may have their debt downgraded
by ratings agencies.
Diversification may not protect against market risk or loss of