Bond ETFs Vs Bond Mutual Funds

May 13, 2019

Bond ETFs Don't Penalize You For Holding Them

An additional—and often overlooked—benefit of bond ETFs is that they don't penalize buy-and-hold shareholders when the underlying bond markets become stressed.

In stressed or illiquid markets, an ETF's share price may drift below its NAV by a significant amount. When that happens, it means the fund's APs and market makers believe the bond pricing service is wrong. Essentially, APs can't liquidate the underlying bonds in the ETF's portfolio for the prices reported by the pricing service; consequently, the ETF's share price develops a discount to NAV. The same thing happens in reverse for premiums to NAV.

Most of the time, AP arbitrage eventually evens out premiums and discounts, even in times of market stress. For more information on how, read "The Next Bond ETF Crash: An ETF Story."

This process is distinct from mutual funds, which guarantee investors the ability to enter and exit the fund at exactly NAV at all times, market stress or no. That's good for investors who want to sell their bond fund—but not so great for the shareholders left behind.

Mutual Fund Holders Subsidize Exit Costs

Here's why: To fill a redemption request, mutual fund managers must give the exiting investor cash equal in value to the fund's NAV. To get that cash, managers must sell bonds in the portfolio.

In normal markets, that's simple. However, in stressed markets, that's harder to do—especially since the managers won't be able to sell the underlying bonds for the prices reported by their pricing service.

As a result, mutual fund managers often have to sell more bonds than the NAV's worth to make up the difference. The shareholders who remain in the fund subsidize that cost.

Furthermore, because mutual funds process their redemptions overnight, instead of intraday, they have to keep cash on hand—creating cash drag on the fund—or maintain a credit facility, which shows up as a fund expense.

Sophisticated Trading Strategies

There are other benefits to the intraday tradability of bonds, too: You can perform all sorts of sophisticated trades on a bond ETF that you can't with a bond mutual fund; for example, you can buy bond ETFs on margin and sell them short.

You can also trade options on bond ETFs; the aforementioned HYG is popular with investors placing puts and calls (read: "15 ETFs With The Most Liquid Options").

But even if you aren't interested in these more sophisticated trading strategies, you can rest assured that bond markets are more liquid and priced more fairly than they used to be, simply because bond ETFs exist.

Contact Lara Crigger at [email protected]

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