ETF Mythbusting: Price Matters For Bond Investors

by: Matt Tucker, CFA

Recently, a friend was venting to me about his real estate woes. The problem? The latest uptick in the housing market got him thinking about selling his house. He checked to see what houses in his area were selling for, took a look at some online estimates, and even got the house appraised. Confident he knew what his place was worth, he put it on the market. But when the final sale price came in, it was less than what he had been expecting. As he complained to me, "What's the point of an appraisal if that's not the price you really get?"

Anyone who has ever participated in a real estate transaction is familiar with this dynamic. Appraisals and other price estimates can give you an idea of what a property is worth, but when push comes to shove, it's the buyers and sellers who determine price. And, at the end of the day, price is all that really matters. My friend can complain until he is blue in the face about the injustice of it all, but it's not going to change anything.

As we like to say on the trading desk, a trade is an agreement on price, but fundamentally a disagreement on value between buyers and sellers -- otherwise, a transaction would not occur. Incidentally, this same scenario exists in the bond market. For example, lately there has been much ado about volatile markets causing bond ETFs to trade at a discount to their underlying portfolios, or net asset values (NAVs). And it's easy to understand why this may cause some anxiety. After all, if you sell your bond ETF at a discount to NAV, you're going to get less than what the fund's aggregate underlying bonds are "worth," right?

I put "worth" in quotations not to be flippant, but to draw a parallel to the real estate example -- namely, that a bond ETF's NAV is similar to a housing appraisal: A helpful guide? Absolutely. Completely accurate? Usually not. Here's why:

Bonds trade over the counter (OTC), which means that there's little transparency into bond pricing. Unlike the stock market, where investors can see the bid and ask price of securities throughout the trading day, a bond's market price is determined privately between a buyer and seller. More importantly, most bonds do not trade every day. Because of this, the estimate of a bond ETF's underlying portfolio is exactly that -- an estimate (usually based on the last known transaction price of each bond or the prices of "similar" bonds). This is a challenge not just for bond ETFs, but also for mutual funds and even individual bond positions. It's just the reality of dealing with a market where securities are not always trading.

In contrast, the market price of a bond ETF is what buyers and sellers on the exchange are willing to transact at right now. While it might differ from the NAV of the ETF's underlying portfolio (sometimes it's more, sometimes it's less), the ETF is reflecting the most current information available, as opposed to an educated guess based on potentially stale prices. The fact that bond ETFs shed light on an otherwise opaque and sometimes illiquid market is actually one of their greatest benefits.

In one of the best articles I've read on this subject, Matt Hougan of IndexUniverse had this to say: "Bond markets are illiquid, and investing in illiquid assets has a cost -- if you want to sell something illiquid during periods of market distress, you're going to get less than you'd like." And that's assuming you can sell it at all. In an extremely illiquid market (like the bond market meltdown of 2008), individual bond investors have few options for unloading unwanted securities. Bond ETF investors, on the other hand, continue to transact -- and at prices based on real-time information.

Of course, much like my friend's real estate transaction, not everyone is always happy with the price at which they can buy or sell an ETF, much less an individual bond. That's the challenge of dealing in the OTC bond market. What the ETF does give you is a view into where you can trade at a given point in time, so that you can make more informed decisions about your portfolio. And that is something my friend sure wishes he had had for his house.

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