Are Bond ETFs More Liquid Than Bonds?

What Happens To Bond ETF Liquidity If Rates Rise?

What happens if interest rates rise and liquidity dries up from the underlying bond market altogether? Will investors lose their shirts on mispriced ETFs and enormous discounts to NAV?

Not exactly.

For starters, a bond ETF's price, even at a discount to NAV, may actually be a better measure of the fair value of its portfolio than the prices of its underlying bonds:

  • Individual bond values are hard to calculate. Without an official exchange, there's no single agreed-upon price for the value of any particular bond.
  • Fund managers need accurate bond prices to calculate NAV. They rely on bond pricing services, which estimate the value of individual bonds based on reported trades, trading desk surveys, matrix models and so on.
  • In stressed markets, an ETF's price may fall below its reported NAV. When that happens, it essentially means the APs think the bond pricing service is wrong; bond price estimates sometimes lag major moves in the market, after all. In other words, the APs don't believe they can actually liquidate the underlying bonds for their reported values.
  • Large premiums and discounts don't necessarily signal mispricing in a bond ETF. Instead, the ETF may be performing price discovery for the value of its underlying bonds. This is more likely the case if the ETF has high secondary liquidity, meaning its shares trade regularly, and with high volume.

Secondly, if a bond panic does occur, investors who buy and hold a bond ETF are safer than those who buy and hold a bond mutual fund.

  • Bond mutual funds do buy and sell exactly at NAV in times of market stress. Trading exactly at NAV shields shareholders who want to exit during times of market stress from the true costs of liquidating that portfolio. But what about the shareholders who don't sell?
  • It's tough to fulfill redemption requests during a bond panic. To fill a redemption request, mutual fund managers must give exiting investors cash equal in value to NAV. In normal markets, managers would just sell bonds, but in stressed markets, that's not as easy to do. After all, APs have proven that it's not possible to sell the underlying bonds for the prices given by the bond pricing service. So mutual funds often have to sell more bonds than the NAV's worth to make up the difference.
  • Buy-and-hold bond mutual fund investors subsidize the costs of investors who flee. Someone has to absorb that cost. Plus, because funds process redemptions overnight, they must keep cash on hand—creating cash drag on returnsor maintain a credit facility, which shows up as a fund expense. As a result, buy-and-hold bond mutual fund investors are often penalized for staying in their fund during periods of market stress.

Next: How Do Bond ETFs Work?

Other Articles Of Interest

Leveraged And Inverse ETFs: Understanding Monthly Resets
Bond ETFs Vs. Bonds: Which Are Better?

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