Bond ETFs in Down Markets

June 25, 2013

interestratesInterest rates have been rising since May and this has affected all areas of the bond market, but in many cases, bond ETFs were hit harder than bond funds. Barron’s wrote about bond ETFs that lost more than their underlying assets in May. “iShares iBoxx High Yield Corporate Bond’s (HYG) market price dropped 2.6% for the month, much worse than the underlying assets’ 1% decline.”

Following the market’s June 20 selloff, Barron’s explained that ETFs can be harder to sell in down markets: “Arbitrage traders can keep the price of an ETF and the underlying holdings moving closely together most of the time. But they can (or won’t) keep up in a giant selloff.”

These are two of the reasons why we prefer bond funds to bond ETFs. Given the recent volatility in the bond market, we thought it was a good time to re-visit why we prefer bond funds to bond ETFs (we first wrote about this in the March 2013 in NoLoad FundX and Janet Brown wrote about it on the Forbes Intelligent Investing blog that month, too).

1. Bond funds add value through active management

One tenet of index investors is that few active managers beat their benchmark index over time. In fixed income, however, there are many managers who have beaten their benchmark consistently for many years. Just as important, active fixed income managers make risk management a priority by employing teams of credit analysts. This expert credit research helps reduce default rates and improve recovery results. Actively managed funds can also consider investing in less widely traded bonds that index-based ETFs may not have access to.

2. Bond funds have proven track records

The first equity ETF began 20 years ago, but bond ETFs are relatively new; the oldest bond ETF is just six years old, and most are less than three years old. Bond mutual funds, on the other hand, have been around for decades. We take comfort in knowing the actual performance of various strategies through good and bad markets. We have also seen that bond funds that are designed to track major indexes have rarely been top performers.

3. Bond funds can’t be sold short

Bond ETFs can be sold short, which means that bond ETFs can be sold, even by people who don’t own shares of the actual ETFs. Essentially, hedge fund managers and other active traders can buy individual bonds that they like and then hedge their overall bond market exposure by short sell¬ing an index-based ETF. This can lead to increased volatility in ETFs – especially for those that trade high-yield bonds. We have seen that bond ETFs are generally more volatile than bond funds, and one of our goals in managing fixed income is to limit volatility.

4. Bond funds trade at NAV

ETFs have arrangements with market makers to provide liquidity, and ETFs can be traded throughout the trading day. But as we noted last month, there is no guarantee that ETFs will trade at the value of their underlying net assets (NAV). Bonds are more expensive to trade than stocks, so most bond ETFs typically trade slightly above NAV to compensate ETF market makers for these added trading costs. In a down market, these same bond ETFs may trade below NAV, sometimes substantially, when there are more sellers than buyers and market makers are unwilling to bring the ETFs back to NAV. Bond funds always trade at NAV, so you don’t ever pay a premium at the time of your purchase and you also don’t risk selling below NAV if you sell into a down market.

5. Bond funds have offered better risk-adjusted performance

Consider the Vanguard Total Bond Market Fund, which has both a mutual fund share class (VBMFX) and an ETF share class (BND). Since both tickers represent the same fund portfolio, they should have identical performance, and over time, they do. But BND is more volatile, partly for the reasons described above. Why accept greater volatility if you don’t get compensated by better performance? High yield bond funds like Janus High-Yield (JAHYX) or Fidelity High Income (SPHIX) have consistently performed better than high yield ETFs like SPDR Barclays Capital High Yield (JNK) and iShares iBoxx High Yield (HYG) and with less volatility.

Although we generally prefer bond funds, we do use some bond ETFs at times. For example, if we add to junk bonds in times of stress, we may buy JNK when it is trading at a discount. We also use bond ETFs in categories that are less volatile like very short-term Treasuries where lower expenses add the most value. And some of the newer bond ETFs show signs of being real competitors for bond funds down the road.

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