Content provided by Marc Pfeffer, CLS Senior Portfolio Manager
Currently, there are nearly 300 fixed income exchange traded funds (ETFs) in the marketplace. That is four times as many as in 2008. Demand continues to be strong for fixed income ETFs, and for some good reasons.
The Pros: Liquidity, Diversity, Price, and Efficiency
- Fixed income ETFs are more liquid than underlying bonds, and most are liquid to trade. They’re typically easier to trade than the underlying bonds, as bonds trade less frequently than stocks, and their true price is harder to know.
- ETFs are diversified portfolios that allow investors to gain diversified, fixed income exposure at a low price.
- Because of the increased demand and liquidity for fixed income ETFs, they do a better job at price discovery than underlying bonds. In other words, despite sometimes-sensational press that fixed income ETFs are not trading at their underlying bonds’ net asset values (NAV), fixed income ETFs are not broken. They are quicker and better at adjusting to new market realities.
- Bond ETFs offer a more efficient way for investors to gain exposure to various interest-rate and credit risks.
The Cons: Are They Really That Liquid?
Fixed income ETFs work well, but one problem is that investors often lose sight of trading costs and transparency. The lack of liquidity in bond portfolios makes it more difficult and expensive to build a basket of securities and hedge larger trades.
For example, one metric for gauging an ETF’s trading cost is the bid-ask spread, the price discrepancy between what buyers pay and sellers receive. Market makers, who match buyers and sellers, collect the difference. The buyers effectively pay half the spread, the sellers the other half. Despite prospectively lower expected returns, trading costs are generally higher for bond ETFs than stock ETFs: The average fixed income ETF currently carries a bid-ask spread of 0.39%, while the average for stock ETFs is 0.31%. Another way to look at it is that there are many large, frequently traded stock ETFs that trade with an average bid-ask of 0.1% or lower. Only 80 bond ETFs can say that.
In Sum: A Pretty Good Deal
They’re not perfect yet, but I believe a fully diversified portfolio of fixed income securities, which an ETF can represent, is more likely to provide a better investor experience over time – i.e., better total return, less credit risk, and a more suitable investment to diversify other asset classes, such as equities. As a portfolio manager and active trader of fixed income ETFs, I am a huge fan of the securities. You just have to know what you’re buying.