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 mind:
- Stocks trade on an exchange where their prices are publicly available throughout the day. There is generally an active secondary market for most stocks, meaning that buyers can typically finds sellers and 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.
- Bonds trade over-the-counter (OTC) where their prices are negotiated privately between buyers and sellers. 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 be.
So how do these differences affect bond and stock ETFs? The impact can be seen in two big ways:
1. 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 Market Index.
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 portfolio manager 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 for you.
2. 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 (NAV) of an equity ETF is typically very close to the ETF's closing price.
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 on 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 best 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.
Disclaimer: 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 principal.