Why Are Bond ETFs Bad for Investors?

Bond Exchange-Traded Funds (ETFs) have gained popularity as investment vehicles, touted for diversification and ease of trading. They offer exposure to a broad bond portfolio through a single security, traded like stocks. While bond ETFs offer advantages, investors should understand characteristics that can lead to unexpected outcomes, as their structure and market behavior reveal problematic aspects.

Impact of Interest Rate Movements

Bond prices and interest rates exhibit an inverse relationship: as interest rates rise, the market value of existing bonds falls. This principle applies directly to bond ETFs, impacting their performance. Higher interest rates make older, lower-paying bonds less attractive, decreasing their market prices. Conversely, lower rates make existing higher-paying bonds more valuable, increasing their prices.

The sensitivity of a bond or bond ETF to interest rate changes is quantified by its duration. Duration is expressed in years and estimates the percentage change in a bond’s price for a 1% change in interest rates. For example, a bond ETF with a duration of five years is expected to decrease in value by approximately 5% if interest rates rise by one percentage point. This metric helps investors gauge potential capital losses during rising interest rates.

Unlike individual bonds, which mature and return face value, bond ETFs do not mature. The fund buys and sells bonds to maintain its target duration or investment objective. This perpetual nature means investors are exposed to interest rate risk, without receiving principal back at a fixed date. If interest rates rise and remain elevated, bond ETF holders can experience sustained capital losses without the recovery of holding individual bonds to maturity.

Trading Characteristics and Market Pricing

Bond ETFs trade on stock exchanges throughout the day, offering flexibility to trade during market hours. This differs from traditional bond mutual funds, priced only once daily after market close. While intraday liquidity is often highlighted as an advantage, it introduces complexities regarding market pricing.

The market price of a bond ETF can diverge from its Net Asset Value (NAV), representing the per-share value of underlying bonds. Trading above NAV is a premium; below, a discount. These can arise from imbalances in supply and demand for ETF shares, differences in underlying bond liquidity, or timing discrepancies in bond valuation versus ETF trading.

Investors encounter transaction costs as bid-ask spreads when trading bond ETFs. The bid-ask spread is the difference between a buyer’s highest price and a seller’s lowest. Wider spreads mean higher transaction costs, as investors pay more to buy and receive less to sell. This is pronounced in less liquid bond markets or during market volatility, where underlying bond trading is challenging. While ETFs offer price transparency, fluctuating premiums, discounts, and bid-ask spreads can lead to trading outcomes deviating from the underlying bond portfolio’s perceived value.

Underlying Portfolio Management

Bond ETFs incur expense ratios and management fees, deducted from assets. These fees, ranging from 0.05% to 0.50% or more, accumulate and reduce overall return. In low-interest-rate environments, where bond yields are modest, these fees can consume a substantial portion of income from underlying bonds. This cost can diminish the net yield from bond ETF holdings.

Another consideration is tracking error, the difference between an ETF’s performance and its target index. While ETF managers strive to replicate their index closely, perfect replication is impractical or costly. Factors like transaction costs from buying/selling bonds, cash drag, and sampling techniques (holding a representative subset of the index’s bonds) contribute to tracking error. Thus, ETF returns may not perfectly align with the benchmark.

Investors in bond ETFs do not directly own individual bonds; they own fund shares. This means investors cannot hold specific bonds to maturity for principal return. Fund managers adjust the portfolio by buying and selling bonds to maintain investment strategy, such as target duration or credit quality. This active management, necessary for the ETF’s structure, means investors never receive a bond’s face value at maturity.

Credit and Liquidity Issues

Bond ETFs are exposed to credit risk: the possibility that underlying bond issuers may fail to make interest payments or repay principal. ETFs holding bonds with lower credit ratings, known as high-yield or junk bonds, carry greater default risk. If an issuer within the ETF’s portfolio experiences a credit downgrade or default, the bond’s value, and thus the ETF’s share price, can decline. Even investment-grade bonds, considered safer, are not immune to credit events during economic stress.

While bond ETF shares are liquid and trade readily on exchanges, underlying bond market liquidity varies significantly. Unlike stocks, many bonds (corporate and municipal) trade over-the-counter, not on centralized exchanges, and some trade infrequently. During market stress or high investor outflows, underlying bond market illiquidity can make it challenging for the ETF to buy or sell bonds at fair prices.

This underlying market illiquidity can lead to wider bid-ask spreads and larger discounts to NAV for bond ETFs, as market makers demand greater compensation for transacting in less liquid underlying securities. While ETFs provide a valuable price discovery mechanism, investors may find their ability to exit positions at desirable prices compromised. The inherent liquidity differences between ETF shares and underlying bond holdings create challenges for investors, especially during volatile market environments.