5 questions answered about bond ETFs

Bond ETFs, which trade on an exchange just like stock ETFs, have made it easier and less costly for investors to access virtually every sector of the bond markets. What’s more, these versatile, transparent investments have helped promote market stability by adding liquidity and price transparency in times of stress.

  • How does trading bond ETFs differ from trading individual bonds?

    Unlike stocks, which are traded on a centralized exchange, individual bonds are bought and sold through bond brokers “over the counter,” with buyers and sellers negotiating one-on-one to reach a deal. That structure can make it difficult for investors to find the bonds they’re looking for, and know whether they’ve gotten a good price from a broker.

    Bond ETFs, on the other hand, are traded throughout the day just like stock ETFs, on a centralized exchange such as the New York Stock Exchange. As a result, they can provide investors with their desired exposures to the bond market, with the ease and transparency of stock trading.

    Here’s how it works: Buyers and sellers of bond ETFs meet directly on the exchange, without having to access the underlying bond markets. Instead, their trading activity offers a real-time window into what is happening in those markets. That information, which is visible to all investors—individuals and institutions—helps set the ETF’s price on the market.

  • Could bond ETFs lead to a broad bond market selloff?

    Because bond ETFs are relatively new, some misperceptions have arisen about how they operate in the markets – including the belief that they may influence price movements or trigger a selloff in the broader bond market. In fact, bond ETFs represent a relatively small part of the bond market (see chart below). The price of any investment is largely influenced by investor demand (whether they’re buying and selling). This relationship holds for mutual funds, individual bonds and ETFs alike. So if bond prices were to fall, the value of all three types of investments would experience similar declines.

    As of June 30, 2015 bond ETFs had $318 billion in assets under management, or less than 1% of the total bond market.

    Bond ETFs as % of US Bond Market
    Bond ETFs as a percent of US Bond Market
    Source: BlackRock, Bloomberg and Sifma as of 6/30/2015

  • Are bond ETFs more, or less, liquid than the overall bond market?

    Under normal market conditions, bond ETFs may actually be more liquid than the underlying bonds in its portfolio. That’s because buyers and sellers can transact with each other on the stock exchange without necessarily having to access the underlying market. Even during periods of market stress, when liquidity decreases, bond ETF shares can generally be expected to be at least as liquid as the underlying portfolio securities. At the same time, it's important to know that there can be no assurance that an active trading market for shares of an ETF will be developed or maintained.

    Bond ETFs provide investors with two sources of trading liquidity:

    1) On the stock exchange - ETFs give investors another potential source of liquidity, as investors are not transacting in the bond market but on the exchange. This is how the vast majority of ETFs trade.

    2) Through the creation/redemption process- If there are more sellers than buyers of the ETF on the exchange, then certain brokers can redeem shares of the ETF in exchange for the bonds that make up the fund. These bonds can then be sold individually on the bond market. This process happens in reverse when there are more buyers than sellers (i.e., demand outstrips supply); then, these brokers buy the individual bonds and create new shares of the ETF. Because the creation/ redemption process involves large blocks of shares (typically 50,000 or 100,000 ETF shares), it can help balance market supply and demand for ETFs.

    In other words, in any market, the “exchange trading” of exchange traded funds provides investors with an additional source of liquidity. This is particularly important in stressed markets, as ETFs provide a way for investors to trade bond portfolios even if the underlying bond market is not functioning properly.

  • How do bond ETFs react to stressed markets?

    A stressed market can be defined as a market environment where there are more sellers than buyers, and prices decline sharply. Bond ETFs have weathered many stressed markets, including the credit crisis (2008), the European sovereign debt crisis (2010), the U.S. Treasury downgrade (2011), the Taper Tantrum (2013) and oil selloff (2014).

    Here’s how bond ETFs behaved during each of these events:

    Increased volumes: The trading volume on exchange for many bond ETFs actually increased, as more investors turned to ETFs when it became difficult to transact in the bond market. For example, in April 2013, the month preceding the Taper Tantrum, the average daily volume for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) was approximately $283 million. During the Taper Tantrum period covering May 1, 2013 - July 5, 2013, average daily volume soared to $538 million as many investors were moving out of the high yield market (Sources: BlackRock and Bloomberg).

    No forced selling: Even when ETF shares are redeemed, the ETF is not a forced seller, as might be the case with a mutual fund seeing heavy redemptions. As mentioned above, certain brokers – at their discretion – can exchange ETF shares for bonds. The ETF itself does not need to sell bonds in order to fund redemptions.

    Discounts to NAV:In a market with declining prices, the ETF may trade at a discount (below) its net asset value (NAV), as investors seek prices for the underlying bonds. The discount is a reflection of the challenges of trading in the traditional markets versus the ease—and transparency—of trading ETFs. Thus, in a declining market the bond ETF can often fall in price first, and the NAV will follow as bond trades occur.

  • If there is extreme selling in the market, could the ETF provider restrict me from selling my bond ETF?

    No. Since the buying and selling of bond ETFs is concentrated on centralized market exchanges, as long as the market is open for trading you will be able to sell your bond ETF shares through your brokerage account at the quoted price. So-called “gate” provisions, which limit the amount or frequency of withdrawals in order to prevent a run on the fund, would not come into play even during periods of extreme selling pressure. That’s because creations and redemptions are generally in-kind, meaning that exchanges between the authorized participant and the ETF are made using actual securities rather than cash. As a result, there is no need for the fund’s manager to raise cash to meet redemptions, as there might be with investments such as hedge funds – and thus no need to delay withdrawals. The redeeming AP would simply receive a representative slice of the ETF’s holdings.