The Difference Between Bonds And Bond ETFs

by: Matt Tucker, CFA

Welcome to the third installment of our master class on bond ETFs, where we go beyond the basics to help investors understand the mechanics and benefits of these innovative funds. So far, we've covered the three key elements of a bond ETF and the differences between bond ETFs and stock ETFs.

In both articles, we touched on the concept that individual bonds trade over-the-counter (OTC), and that this has some important implications for bond ETFs. Today we're going to take a deeper dive into that concept and contrast the OTC market with how bond ETFs trade.

We'll start by talking about how a bond trades -- take a look at the illustration below:

Let’s say Customer A wants to buy a bond. In the OTC market, here are the general steps he would need to go through:

  • Customer A calls Broker A to ask if she has the bond available for sale.
  • If Broker A doesn't have the bond, Customer A then needs to call Broker B (and potentially C, D, and E) until he finds a broker that offers the bond he's looking for.
  • When Customer A finds a broker that has the bond, he asks at what price the broker is willing to sell it.
  • If Customer A is unsatisfied with the price, he then needs to call more brokers until he finds one that offers both the bond he's looking for and an agreeable price.
  • Ideally, Customer A wants to find at least two brokers who offer the bond in order to make sure that the price is fair relative to what other brokers offer.

That's a lot of phone calls and negotiations. Not to mention the fact that these brokers are taking calls from other customers throughout this whole process, negotiating prices that Customer A has no way of seeing. This can lead to large disparities in the prices paid by different investors. A broker can sell the same bond to both Customers A and B at the same time -- but at different prices.

Perhaps most importantly, Customers A and B have little visibility into the market. They can't see what brokers are offering the bond they want without making a lot of phone calls. And even then they have no way of knowing if they got the best price available. Was there a Broker C or D that offered a lower price on the same bond? They have no way of knowing.

Let's contrast that with the way that a bond ETF trades:

Unlike individual bonds, bond ETFs trade on an exchange, like the NYSE. The exchange is a centralized trading system that connects buyers and sellers, and prices are quoted continually throughout the trading day. This transparency gives participants a view into how the overall market is valuing an ETF, which in turn can help to narrow spreads and lower transaction costs for investors. If Customers A and B both buy the same bond ETF at the same time, they have largely the same access to inventory and price information, and their execution prices for similar trade sizes are likely to be similar.

For me, this discussion illustrates the core benefits of bond ETFs for most investors. You can see a variety of fixed-income markets trading in real-time on the exchange, everything from Treasuries to corporate bonds to emerging market debt. You can observe the bid and offer prices where the funds trade to get a sense of the transaction costs you might incur. And ETFs trade on an exchange, so you don't need to call your broker to inquire about inventory.

In a nutshell, bond ETFs provide transparency, efficiency and liquidity -- attributes that are traditionally hard to come by in the fixed-income market. The bond ETF democratizes the bond market, providing all investors with similar market information and access. This lets investors spend more time on their investment strategy, and less time on the phone.

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. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. When comparing bonds and ETFs, it should be remembered that management fees associated with fund investments, including ETFs, are not borne by investors in individual bonds.

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