Bond ETFs Vs. Bond Mutual Funds: Which Should You Choose?

Bond ETFs are cheaper, more tradable and more transparent than bond mutual funds. They’re even a better deal in stressed, illiquid markets.

At first glance, there doesn't seem to be much difference between bond mutual funds and bond ETFs. Like mutual funds, bond ETFs roll up hundreds, even thousands, of bonds into a single portfolio at a purchase price significantly less than what it would be to invest in each bond individually. Also like mutual funds, bond ETFs pay regular dividends to investors. And ETFs as well as mutual funds come in a variety of flavors, from Treasurys to municipal bonds, to suit every investor's risk tolerance and income needs.

But look more closely, and you'll see the similarities between the two only run skin deep.

What Is A Bond ETF?

A bond ETF offers bonds in a stocklike wrapper. Though these investment vehicles hold bonds and only bonds, they trade on exchanges like stocks. With ETFs, therefore, investors can get the safety of bonds with the flexibility exchange-trading can provide.

Bond ETFs Cheaper, Tradable

Bond ETFs offer several advantages over mutual funds, including:

• Tradability: You can buy and sell ETF shares at any time during the trading day, even in segments of the bond market where individual issues might trade much less frequently. You can also buy bond ETFs on margin and sell them short, allowing for a greater range of investment strategies. Mutual funds, meanwhile, are only traded once a day after market hours, and you can neither buy mutual funds on margin nor sell them short.
• Transparency: Exchange trading makes ETFs more transparent than mutual funds, and most ETF managers publish a complete listing of their holdings daily. Managers often only publish mutual fund holdings once a quarter.
• Lower total costs: Bond ETFs tend to be cheaper than their mutual funds. Why? Because there is less work involved in running an ETF. As detailed in “ETFs Vs. Mutual Funds: Which Is Right for You?”, the ETF system saves on paperwork, record-keeping, distribution costs and more. The end result? An ETF's total expense ratio is usually lower than that of a comparable mutual fund.

Bond ETF Investors Pay Commissions, Spreads

Bond ETFs aren't without their drawbacks, however.

• Commissions: Every time you buy and sell shares of an ETF, you incur a trading commission. If you regularly invest small amounts of money, such as through regular paycheck contributions to a retirement account, those commissions can quickly add up. Although several commission-free ETF trading platforms have emerged in recent years, you should still check your brokerage's rules before investing.
• Bid/Ask Spreads: Like stocks, an ETF's spread is the difference between the price you pay to acquire a security and the price at which you can sell it. You buy the spread whenever you trade an ETF; it's unavoidable. In the bond market, these spreads can become pretty wide, especially sectors that are already thinly traded or illiquid.
• Premiums/discounts: When you buy or sell a mutual fund, you always transact exactly at the fund's stated net asset value (NAV). ETF prices, however, are influenced by share supply and demand. Though mechanisms exist to keep ETF share prices in line with NAV, they're not always perfect, and sometimes an ETF may trade at high premiums or discounts to NAV.

Do Premiums & Discounts Mean Bond Mutual Funds Are Better Than Bond ETFs?
 

Mutual fund devotees often point out that during times of market distress, bond ETFs may trade with large premiums and discounts. It's true, but that doesn’t mean bond mutual funds are better. In fact, unless you're a panic seller, during volatile times, bond mutual fund investors may be worse off. (See: “Bond ETFs Vs. Bond Mutual Funds: Which Should You Choose?”)

Why?

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. In fact, many bonds don't even trade daily; certain types of municipal bonds, for example, can go weeks or even months between trades.

Fund managers need accurate bond prices to calculate NAV. Mutual fund and ETF managers rely on bond pricing services, which estimate the value of individual bonds based on reported trades, trading desk surveys, matrix models and so on. It's not a sure thing, of course. But it's a good guess.

An ETF’s share price isn’t exactly its NAV. Unlike a mutual fund, whose share price is always its NAV, an ETF's share price may drift from its NAV due to market supply and demand. Premiums develop when prices rise above NAV, and discounts develop when prices fall below NAV. But there's a natural mechanism in place to keep an ETF’s share price and NAV aligned: arbitrage.

APs use arbitrage to keep ETF share prices and NAV in line. A special class of institutional investors known as "authorized participants" (APs) have the ability to create or destroy shares of an ETF at any time. Should an ETF's share price dip below its NAV, APs can make money on the difference by buying up shares of the ETF on the open market and trading them in to the issuer for an "in kind" exchange of the underlying bonds. To profit, the AP simply needs to liquidate those bonds. Likewise, if an ETF's share price rises above NAV, APs can buy up the individual bonds and trade them in for ETF shares. Arbitrage creates a natural buying or selling pressure that tends to keep an ETF's share price and NAV from drifting too far from each other.

In stressed or illiquid markets, an ETF's price may be below its reported NAV by a lot, or for a long period of time. When that happens, it essentially means APs and market makers think the bond pricing service is wrong, and that they’re overestimating prices for the fund's underlying bonds. In other words, the APs don't believe they can actually liquidate the underlying bonds for their reported values. For ETF investors, this means the ETF price falls to a discount to its NAV. (The reverse is true for any premiums that may arise.)

Bond mutual funds guarantee the ability to buy and sell exactly at NAV in times of market stress. That's a good thing. Buying and selling 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?

Buy-and-hold bond mutual fund investors subsidize the costs of investors who leave. To fill a redemption request, mutual fund managers must give the exiting investor cash equal in value to NAV. In normal markets, the fund would just sell bonds to come up with the cash. But in stressed markets, that's harder to pull off. As the APs have already discovered, it’s not possible to sell the underlying bonds for the prices, given by the pricing service. Therefore, mutual funds often have to sell more bonds than the NAV's worth to make up the difference. The shareholders who stay are the ones to absorb that cost. Plus, because funds process redemptions overnight, funds must keep cash on hand—creating cash drag on returns—or maintain a credit facility, which shows up as a fund expense. Thus, buy-and-hold bond mutual fund investors are often penalized for staying in their fund during periods of market stress.

Bond ETFs Vs. Bond Mutual Funds: Making The Choice

Whether a bond ETF or a mutual fund is right for you depends on your goals, of course, but also on your philosophy.

If you believe in the power of active management, then there's likely a mutual fund option with your name on it. Active bond funds remain a relatively new idea in the ETF space, and while some big-name managers troll the ETF waters, the choices pale in comparison to those found in mutual fund land.

If, however, you want lower fees, intraday tradability and the ability to know what you own at all times, then a bond ETF is for you. Furthermore, in stressed or illiquid markets, you aren't penalized for staying in a bond ETF when other investors might leave.
 

Next: Bond ETF Taxation: Three Things You Need To Know

Other Articles Of Interest

Are Bond ETFs More Liquid Than Bonds?
How Do Bond ETFs Work?