Bond ETFs: A Different Perspective

There was a wonderful article titled “Bond ETFs are Popular But Pricing Is a Problem”, written by Eleanor Laise, in the Wall Street Journal Tuesday. The article highlighted many of the shortcomings of bond ETFs, particularly the huge difference between the share price and the underlying Net Asset Value, but despite this phenomenon, investors are still demanding these investment vehicles.

Share prices of many bond ETFs are drifting far from the value of their underlying holdings, which can create big trading cost for investors. Some of the funds are straying from their benchmarks, meaning investors aren’t getting the returns they expected.

None of this has stopped investors from jumping into bond ETFs. The category has snagged over half the new cash flowing into ETFs this year through August, up 52% from the end of 2008.

Many articles covering bond ETFs usually cover the same topics, premium/discount, Net Asset Value/Indicative value and index drift, but rarely do I see any mention that these are exchange traded securities (no pun intended), and thus are subject to the whims of the market. All market traded securities are at the mercy of the “Animal Spirits”, which is the title of a book written by George A. Akerlof and Robert J. Shiller (Case Shiller Index co-founder). This book highlights how human emotions play a major factor in the markets and the economy.

The undeniable human nature of fear and greed is a clear example of these emotions at work when these bond ETFs continue to appreciate without regards for the underlying fundamentals. Historically, stocks and bonds have been negatively correlated, largely because most bonds aren’t traded daily, so the supply is much more limited than stocks. Unfortunately, many individual investors as well as financial advisors do not understand that the illiquid nature of bonds causes their corresponding ETFs to stray away from tracking the performance and holdings of their underlying benchmarks, thus defying what they were originally set out to do.

Today’s investor demographic is largely dominated by baby boomers that still have vivid and frightening memories of the 2008 market crash. These baby boomers are still gun shy when it comes to investing their retirement nest eggs in equities -- thus the huge amounts cash, parked on the sidelines being held in money market funds. As the article highlights, the majority of the new assets were allocated to bond ETFs. Many, however, are expecting bond ETFs to have the same security characterizes of an actual bond.

Nothing could be further from the truth. Barrier for entry into the individual bond market can be quite steep, since most individual bonds don’t trade daily. Also, the cost for purchasing a bond is substantially higher than the price of one ETF. On the surface, these funds appear better than traditional mutual funds with bond holdings, due to the transparency and liquidity ETFs offer. On the flip side, bond mutual funds don’t trade on an exchange, so they are not as exposed to the ebbs and flows of the equity market.

Below find a listing of the top 5 bond ETFs, by trading volume and assets under management, and a correlation matrix that compares each bond to its peer and the S&P 500 Index:

*Data provided by Bloomberg llp

*Data provided by Bloomberg llp

*Data provided by Bloomberg llp

After reviewing these charts, you can quickly see that institutional ownership is a factor, but most of these funds are owned by retail investors, who tend to pay a bit more for their holding versus an institution. Clearly a case of fear and greed has been demonstrated after reviewing the ownership of these bond funds. This is also a testament to the ETF movement. The fact that retail and institutional investors are willing to utilize ETFs over actual bonds or mutual funds to facilitate their fixed income portion of their overall asset allocation speaks volumes. As more baby boomers begin to approach retirement, bond ETFs will continue to increase in demand and that will only increase the probability that bond ETFs will continue to trade at large premiums.

Disclosure: Long LQD

Comments

[RAPROX:]

Bond EFTs are the best and most liquid way to participate in the bond market for retail investors. You don't have to be a bond picker and your risk is spread across a broad portfolio of bonds. The monthly income is important for retiring boomers as well.

Oct 07 10:03 AM

[RAPROX:]

To you list I would add HYD and HYG. HYD allows exposure to the high-level muni market. HYG is another large high-yield corp bond fund like JNK.

Oct 07 10:07 AM

[RAPROX:]

To you list I would add HYD and HYG. HYD allows exposure to the high-level muni market. HYG is another large high-yield corp bond fund like JNK.

Oct 07 10:08 AM