In Defense of Bond ETFs

In Defense of Bond ETFs

Liquidity, or the lack of it, is what everyone seems to be talking about relative to the bond market these days. What does it mean and why should we care? Don’t we just buy and hold bonds until they mature? Not so much anymore.

A security is perceived to be liquid if quantities, large and small, can be sold quickly and at a fair price. By their nature, fixed income (or bond) markets have always been less liquid than equity markets. A corporation like General Electric for example, has one stock but has issued over 700 different bonds, each with unique terms (due date and interest rate) and security provisions. As the bond market has evolved away from privately negotiated transactions to electronic trading, investors have started to worry about the liquidity of individual bonds as well as various types of bond funds, both mutual funds and ETFs. Recently, some prognosticators have suggested that bond ETFs are responsible for the volatility in high-yield, and that bond ETFs could ultimately exacerbate a selloff in the bond market. While not without risk, we believe many of the fears circulating about bond ETFs have been overstated.

It is important to acknowledge that liquidity in the fixed income market has changed, however, and that these factors have contributed to changes worth understanding. Prior to the 2008 financial crisis, banks held inventories of bonds in order to facilitate trading and support a stable market environment for buyers and sellers. Since the financial crisis, regulations designed to reduce risk in the financial system have limited banks’ ability and willingness to hold large quantities of bonds on their balance sheets. As a result, there are fewer traditional market makers (broker-dealers) during a time when bond issuances have skyrocketed in response to the Fed’s low interest rate policy.  A greater supply of bonds and fewer traders has resulted in an expansion in pre-packaged bond portfolios, principally offered in an increasing variety of lower cost ETFs to fixed income investors. The rise of bond ETFs reflects the marketplace’s response to changes in the environment.  It is their popularity that has now caused concern.

Today, over $300 billion is invested in the universe of bond ETFs, and while this is a large absolute number, it represents a very small percentage, only 0.4%, of the total global bond market.1 Bond ETFs allow retail investors to achieve diversified market exposure at low cost in a transparent vehicle that can be purchased or sold throughout the day. The concern is that many bonds trade by some form of electronic appointment and could lead to a less liquid environment if everyone heads for the doors at the same time.  While most investors are familiar with the basics and would agree that diversification, lower costs, and transparency are attractive characteristics, not as many people are familiar with the unique structure of a bond ETF – which is important to understand in order to comment on liquidity. Unlike mutual funds where investors purchase shares directly from the fund company, retail investors purchase ETF shares directly from another retail investor who is selling shares in what is known as the secondary market. Most of the demand for ETFs is satisfied by shares available on the exchange in the secondary market. In fact, according to the Investment Company Institute, 81% of total trading in bond ETFs is done on the exchange in the secondary market.2 As the trading volume increases, the difference (or spread) between bid and ask prices compresses, so the security becomes cheaper to purchase and sell, thus it is considered more liquid.

Now that we have an understanding of the mechanics, how have these investments fared during periods of market stress? The bond ETF universe was tested and performed reasonably during both the 2008 financial crisis and the 2013 ‘taper tantrum’ that led to a sell-off in the bond market. While underlying activity slowed, bond ETFs have functioned efficiently and traded continuously. Some briefly traded at discounts of approximately 2% to their net-asset-value (NAV), a small compromise to liquidity. Most recovered quickly. Investors who held on and allowed the dust to settle did better than those who sold during the period of stress.1

ETFs are yet another tool in an investor’s kit. Regardless of whether you own individual bonds, mutual funds, or ETFs, it is most important to understand your underlying exposures.  When interest rates are low, there is a temptation to look for higher yield but that comes by adding risk – either extending duration or lowering quality.  A portfolio of shorter term, higher quality bonds will tend to be more liquid than longer term, lower quality or complex bonds.  While we have confidence in the ETF structure in general, Sand Hill’s bond strategy emphasizes liquid, high-quality bonds.  Finally, an investor’s objectives, tolerance for risk and portfolio size guide the decision as to which vehicle is most appropriate.

1 Source: Blackrock – http://www.blackrock.com/corporate/en-pt/literature/whitepaper/viewpoint-bond-etfs-benefits-challenges-opportunities-july-2015.pdf
2 Source: Investment Company Institute, 2015 Investment Company Fact Book, http://www.icifactbook.org/fb_ch3.html

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