Bond Mutual Funds: Worse Than Bond ETFs?

July 11, 2013

As  a long-term investor, if you don’t like bond ETFs, you should hate bond mutual funds.

There’s been a lot of talk recently about the fact that bond ETFs can trade to large discounts during periods of market distress. The reporting has been histrionic, arguing largely that ETFs aren’t a good vehicle for gaining bond exposure. The implication is that mutual funds are a better choice.

The irony of these arguments is that, by their own logic, they suggest the reverse; that bond mutual funds actually have bigger problems than bond ETFs.

The truth is, neither vehicle is perfect.

Bond markets are illiquid, and investing in illiquid markets 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. What’s important to realize is that the way you pay the piper for buying illiquid assets is different depending on whether you invest in a mutual fund or an ETF.

How Bond Funds (ETFs And Mutual Funds) Calculate NAV

The first step in understanding the issue here is to understand how net asset values are calculated for both ETFs and mutual funds.

The place to start is with equity investments. For equity mutual funds or equity ETFs, NAV calculations are simple. Take an ETF that holds all 500 stocks in the S&P 500 Index. To calculate the NAV, all you have to do, essentially, is look at the closing price for all the stocks in the S&P 500.

For bond ETFs—and particularly for bond ETFs tracking illiquid corners of the fixed-income market like municipal bonds—it’s trickier. There’s no official exchange for municipal bonds, and no consolidated tape, so there is no one agreed-upon price for what the value of any particular bond may be. Many muni bonds don’t even trade on a daily basis. They may go days, weeks or months between trades.

To calculate the NAV for a fund like the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB), iShares relies primarily on bond pricing services. These prices are “provided directly from one or more broker-dealers, market makers, or independent third-party pricing services which may use matrix pricing and valuation models to derive values.”

In other words, it is the job of the bond pricing services to guess what a given bond is worth at the end of each day. They base those guesses on reported trades, surveys of bond trading desks, instant messenger chatter, or derivative pricing models that reference other areas of the market to estimate the value of individual bonds. They're smart, but they’re still just guesses.

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