3 Reasons Why You Should Avoid ETF Bond Funds
Bonds promise security in a world prone to volatility. However, there are several different bond-related options, and they’re definitely not all the same.
One type that has gained a lot of attention recently are ETF bond funds.
Are they worth your time? More importantly, are they worth your money?
As it turns out, the answer is no in both cases.
What Are ETF Bond Funds?
Before we get into why they’re not good news for your investing, let’s learn a bit more about what these financial tools actually are. Despite having similar sounding names, bonds and ETF bond funds are not the same things.
Actually, most professionals would not even put them into the same class of assets simply because market forces have so much more impact on bond funds than on bonds.
Really, they’re nothing more than a market tracker. ETF bond funds work like mutual funds in a way, as they hold many different bonds. However, unlike mutual funds, ETF bond funds are traded throughout the day, similar to how stocks are traded.
They are not traded on a once daily basis on net asset value. Instead, they are traded at a discount or a premium relative to the NAV of the fund’s underlying shares.
Often, there is a minimal spread between the two because independent agents both create and liquidate shares. These agents buy securities underlying the funds and then package them up into ETF shares. These are then sent to the fund company.
Liquidation of the shares is just the reverse of this process. Any significant spread between the two points would simply be arbitraged away.
All told, ETF bond funds hold about $500 billion in assets, which is less than just 1% of the $100 trillion market for bonds.
Illusion of Liquidity
The concept that underlies stocks works well. You can trade and make a profit easily because they are liquid. However, the strength that underlies bonds is different.
They are not liquid. That means applying the principles that relate to stocks to bonds makes little sense to a seasoned investor (although plenty have bought into the falsehood of ETF bond funds).
The real issue revolving around ETF bond funds is that if investors choose to sell fund shares, and there aren’t enough ETF buyers, the fund manager will be required to sell shares of the underlying securities in order to meet redemptions.
However, that sort of sudden selloff in an illiquid market can force the manager to sell at any price, which will collapse share prices.
“These funds offer daily or even intraday liquidity to investors while holding assets that are hard to sell immediately, thus making the funds vulnerable to liquidity risk,” U.S. Federal Reserve Vice Chair Stanley Fischer said in a speech in March 2015 in Germany, pointing directly to ETFs and saying they have mushroomed in size while tracking indexes of “relatively illiquid” assets.
As William J. Bernstein notes in his book Rational Expectations: Asset Allocation for Investing Adults, “This mechanism works well with stocks, which are highly liquid, but not with bonds, which are not. There is, for example, only one commonly traded class of Ford Motor Company stock. By contrast, Ford has a range of bonds of varying issue dates, coupons, and maturities. Since there are so many more individual bonds than stocks, the bonds can be highly illiquid. During a financial disturbance, when liquidity becomes even thinner, and most corporate bonds trade only ‘by appointment’, the AP mechanism fails, often at a considerable disadvantage to the shareholder. The open-end fund holder, who can always buy and sell at 4 PM NAV, has no such problem.”
If you’re not prepared to take Bernstein’s word for it, you might value Carl Icahn’s input, which echoes Bernstein’s warning to avoid ETF bond funds.
Avoiding bond ETFs is a wise move, at least where asset classes in which liquidity is a concern. That can include both municipal bonds and corporate bonds. With that being said, it doesn’t include treasuries (nominal or TIPS) because treasuries usually stay very liquid during financial crises.
This does cause conflict for those using ETFs principally in their accounts.
It might be a wise decision to ensure you hold corporate or municipal bonds in a traditional mutual fund or as individual bonds, rather than as ETF bond funds.
You Can Lose Capital
Losing principal is never a good thing when it comes to your investment. It means that not only have you not gained anything on your investment, but that you’ve actually lost money. You’re considering bonds to avoid that potential debacle, right?
You would assume that ETF bond funds would share the protective properties of actual bonds, but you would be wrong. Investing in ETF bond funds can put your principal at risk.
Finite maturity is the hallmark of individual bonds. No matter what type of individual bond you’re holding, corporate, municipal or treasury, you know when you’ll get your principal back, so long as the issuer does not default. You can plan for the date when you will stop earning interest.
Bond funds are different – they have a staggered trip toward maturity. The fund manager replaces them as the issuer calls them in, as they mature, or as the issuer’s credit is downgraded. That fosters consistent payment delivery, but you do not have a set maturity date. You’re not able to plan effectively, and there is little certainty as to when you’ll break even.
Some ETF bond funds actually provide a negative return (hint: this is bad).
No ETF bond funds are guaranteed to preserve your capital, and with the stock marketing in flux, it means that your ETF investment is going to be as well. Volatility is something that you do not want, particularly if it carries with it the risk of losing what you have invested.
During the last crash, ETFs were amongst the biggest losers.
Can you afford that type of risk?
Your Risk May Be Considerable
Speaking of risk, ETF bond funds carry with them a wide range of different risks that you will not find with conventional bonds. You might be surprised at the number of ETF bond funds that invest in low-quality options.
You might be surprised at the number of ETF bond funds that invest in low-quality options. You might be equally surprised at the numbers that use borrowed money to “pump” up the gains attributed to the fund.
That’s not a pretty picture.
If you feel compelled to invest in ETF bond funds (which we hope you do not), make sure to check out the 200-day moving average. This will help you define which funds are “average” and which can actually perform somewhat to your expectations.
There is also the potential for interest rate hikes to eat into your return. Increases can create drops in share prices, and that can increase your risk of losing any gains you’ve made.
If the Fed decided to increase the interest rate by 1%, you could see your ETF bond funds drop by 10% to 20%.
“Bond Yields are well below their average in 2011, so a sudden jump back to normal, or at least to historical average, would be a massive leap,” said Bob Bryan from Business Insider.
Where does this leave investors? Actually, it puts you in a prime position to benefit – from bonds, not ETF bond funds.
We’ve covered a couple of types of risk inherent to ETF bond funds, but let’s give you one more, just to really cement the fact that these are not ideally for most individuals.
Because ETFs are designed to mimic an index, you might suspect that ETF managers will simply buy all bonds within the same index proportion.
The problem is that if that does not happen (and is the case all too often), a tracking error can occur. It sounds benign, but it’s bad news, and can cause your investment to vary widely from the index (higher or lower).
The only real defense is to ensure that you’re investing in bonds, not ETF bond funds. ETFs really aren’t coming to your rescue.
They simply dilute your potential to earn a return on your investment, while compromising the security of your investment principal.
With bonds, there’s no need to trade, and they provide more than the mere illusion that the market is liquid.