Bond ETFs To The Rescue, or Are They?

 In Bond Investing

bond ETFsBond ETFs and Bond Mutual Funds are different animals. An article titled  “Bond Exchange-Traded Funds to the Rescue”  was published in The Wall Street Journal in August 2015 by Richard Prager and Mark K. Wiedman from BlackRock Investment Management Corporation. It is one more example of spin marketing by the ETF industry. The executives of BlackRock seem to be worried about bond ETFs suffering when interest rates go back up.

 

With respect to the executives at BlackRock, I would like to comment on the article and add counter views and arguments where I feel they are necessary.

You don’t need to trade bonds

From the WSJ:

“The near-collapse of the financial system in 2008 left us all wary of hidden risks. Now, with the Federal Reserve set to raise rates, commentators are wondering whether bond exchange-traded funds pose the next danger to financial markets. We suggest instead that bond ETFs promote market stability, add liquidity and improve price discovery.”

First of all, individual investors rarely need to trade bonds. If your investment approach is inline with the Dedicated Portfolio Theory, then bonds are only your investment vehicle. You simply purchase bonds and hold them until they mature.

On the other hand, if the Modern Portfolio Theory is your investment approach, you need to keep bonds in your investment portfolio. This adds stability and decreases volatility in your portfolio, however, you need a periodic re-balancing.

One of the main reasons that bond ETFs were created is for the ease of re-balancing. Bond ETFs were created to provide an easy and transparent way to buy and sell bonds. However, bond ETFs don’t have a maturity date, which gives them unlimited duration risk, or interest rates risk.

Also, holding the fixed-income portion of your portfolio in individual bonds provides protection against interest rate hikes. Re-balancing can be made without selling the bonds; you just reinvest interest from the bonds into equities.

The statistics in this article also make apparent the dangers of holding your assets in bond ETFs.

Bond ETFs hold a less than 1% share of the $100 trillion bond market. This means that when large institutional investors, like insurance companies or pension funds, begin to sell individual bonds, the bond ETF market will collapse.

Bond ETFs provide an “illusion” of the market’s liquidity

From the WSJ:

“Bonds traditionally have lacked a central market where buyers and sellers meet, post prices, and trade anonymously. Instead, banks have stood in between investors, and put their balance sheets at risk to hold bonds. After the financial crisis, the increased capital costs that were required to meet new regulatory demands has made holding bonds, especially corporate bonds, much more expensive for banks. Bank inventories of corporate bonds have halved since 2008, while the total supply of corporate bonds has more than doubled, according to the Federal Reserve Bank of New York.”

Bond ETFs provide an “illusion” of the market’s liquidity. It confirms that the bond ETF market is simply a derivative market. When shares of the ETF are handled without the need to change hands in underlying assets, this proves that it’s a shadow financial market.

Money managers began using these types of derivatives to overcome liquidity problems. Building cash buffers for potential outflows, market professionals buy bond ETFs, which make the underlying markets less liquid. However, using derivatives on a systemic basis represents increased leverage and therefore greater risk in future months and years.

Institutional investors also use ETFs to hedge portfolios of individual bonds. When the price of bonds go down, money managers will all sell ETFs to meet redemption requests and to protect portfolios. This brings up the question: who should buy bond ETFs when the market drops?

Illiquid markets

From the WSJ:

“Professional traders—insurers, banks, asset managers—keep the prices of bond ETFs and the value of the underlying bonds in sync. If the fund shares trade below the value of the bonds held by the fund, a “market maker” will buy the shares and sell the underlying bonds at a profit.”

So what happens if a “market maker” buys the ETFs and then discovers that there are no buyers for the underlying bonds? The authors are assuming there will always be liquid markets.

This may be true may be true most of the time, however, selling underlying bonds in illiquid markets will cause a further drop in the underlying price. This causes a dramatic drop of the bond ETF Net Asset Value (NAV), and consequently, a drop in bond ETF prices.

It is exactly what happened with the Third Avenue Focused Credit Fund (TFCIX) in November 2015. An illiquid junk bond market caused cash crunch of the funds and inability to execute redemption requests.

In conclusion, bond ETFs may be a great investment tool during certain periods. However, the underlying danger I’ve laid out should make you leery of using them as a regular investment vehicle.

Instead, move the fixed income portion of your investment portfolio into individual bonds. Hold the bonds until maturity and be protected from future volatility in the bond market.

 

Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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