One of the most common questions we get at ETF.com is, what's the difference between an ETF and a mutual fund?
Usually, our answer is some combination of "better tradability + more transparency + lower costs.” ETFs trade intraday on exchanges like stocks, they regularly disclose their holdings, and they rely on authorized participants (APs) to create and redeem shares and keep prices in line. That last characteristic helps to lower fund expenses and reduce ETFs' tax burden, and as such, attracts the lion's share of attention from investors.
However, it's easy to overlook how much tradability can matter—especially in the fixed income space, where ETFs have had a profound impact on the way people invest. Bond ETFs have created, quite literally, a fairer and more liquid underlying market—something that benefits everybody, regardless of their preferred investment vehicle.
Bond ETFs Are More Liquid
Like bond mutual funds, bond ETFs package hundreds—sometimes thousands—of individual bonds into a single portfolio at a price significantly less than the cost of going to the over-the-counter (OTC) markets and buying each bond individually.
However, unlike mutual funds, bond ETFs can be bought and sold at any time during the trading day. In contrast, mutual funds trade only once a day, after market close.
Intraday ETF trading acts like a shot in the arm of liquidity for markets that trade less frequently or on different schedules than the U.S. market. Consider municipal bonds, some of which go weeks, even months between each trade. With a municipal bond ETF, however, investors can add or reduce their positions at any time, multiple times, during a single trading day.
That's a huge plus for active traders, and indeed, the exchange-traded nature of bond ETFs has led to the curious situation of bond ETFs making their underlying markets more liquid, simply by the fact of their existence.
It's common for bond ETFs to trade with much higher volumes than their underlying bonds; for example, the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) trades roughly $1.5 billion in average volume daily, while the average bond held by HYG trades an average of $2.5 million daily (read: "Are Bond ETFs More Liquid Than Bonds?").
Bond ETFs Aid In Price Discovery
But it actually goes even deeper than that, because bond ETFs aid in price discovery for the underlying bonds themselves (something that bond mutual funds, with their once-a-day trading schedule, haven't been able to do).
Because individual bonds are traded OTC, traditionally it's been difficult to assess the fair value price for any particular bond. As a result, mutual fund and ETF managers use bond pricing services to give a best-guess estimate of individual bond values. Using those bond prices, the managers then calculate the net asset value (NAV) of their funds.
However, bond pricing services aren't always on target. These services base their estimates on what prices the managers would receive were they to start selling bonds from the portfolio immediately; meaning, at fire-sale prices. That sell-at-any-cost price will always be less than what you could pay to buy the bond, which in turn depresses the NAVs of all bond ETFs.
Furthermore, pricing services still need to come up with prices for bonds that don't trade frequently, or at all, during a trading day. Often, they'll simply carry over the bond's last traded price as necessary—which can create a sharp pricing disconnect when the bond actually trades again.
ETFs, however, rely on the AP arbitrage to keep their share prices in line with NAV, a mechanism that works pretty well at keeping share price and NAV in tandem. As a result, it's common for the share price of a bond ETF to be a better approximation of the total aggregate value of the bonds in its portfolio than what could be gotten through a pricing service (read: "Fixed Income ETFs: What Happens During Bond Panics?").