Busting two myths about bond ETF liquidity

February 19, 2019

 
Adam DeSanctis

Adam DeSanctis
Analyst, Vanguard U.S. ETF
Capital Markets Team

With the popularity of bond ETFs growing, it may be time to understand thoroughly how bond ETFs remain highly tradable—even in roiled markets.

Over the past decade, issuers have introduced more than 300 bond ETFs, and assets under management have grown to more than $650 billion across the industry.1 Growth has accelerated since the first bond ETFs came to market 16 years ago.

The reasons for this growth are clear, but doubts about bond ETFs persist among some investors who worry that when markets turn volatile, the liquidity of bond ETFs will drop, making trading potentially perilous. Such fears are off the mark.

The two layers of liquidity inherent in ETFs—the secondary market on the exchange and the primary market, where shares are created and redeemed with the issuer—help insulate bond ETFs from their less liquid underlying constituents. Because about 80% of the trades occur in the secondary market,2 fixed income ETFs expose investors to a broad and diverse set of bonds with much tighter bid-ask spreads than if they traded the same bonds individually.

But this doesn't eliminate concerns that many investors have regarding bond ETFs. What if the liquidity of the ETF isn't there? And if liquidity dries up, what happens to your investor's assets? Those are valid concerns. We'll examine a few myths and realities about how bond ETFs trade and apply the results of our analysis to help set future expectations.

Understanding bond markets

One of the major differences between equity and fixed income ETFs and their underlying portfolios is the marketplaces where they trade.

Equities trade on exchanges and are governed by regulations that require interexchange routing procedures—all of which give investors the best possible prices across venues. This creates a reasonably centralized marketplace where investors can benefit from pooled liquidity. Because of this centralization, it’s quite easy to execute trades of multiple securities at once.

Trading fixed income securities, and corporate bonds in particular, is quite different from trading equities. For example, corporate bonds trade via a fragmented dealer network, with multiple dealers offering separate pools of liquidity that investors must evaluate.

This means that the bond market is less transparent than the equities marketplace and that it can be difficult to know the true price of a bond. It also adds operational complexity, making it more challenging to trade a portfolio's securities in a single execution.

In these nuances reside some misunderstandings, so let's turn our attention to debunking a few bond ETF myths.

Insights from the U.S. ETF Capital Markets Desk

As we explore two bond ETF trading myths and realities below, remember that while individual bonds trade in diffuse, noncentralized markets, fixed income ETFs are listed on exchanges, bringing all those far-flung bonds together in exchange-traded packages.

This makes most bond ETFs more liquid than the securities they hold, even in turbulent markets. The liquidity effect of bond ETFs can actually make the ETFs themselves price-discovery mechanisms at times when underlying markets in individual bonds may be roiled and illiquid.

The point is that concerns among some investors that bond ETFs can be very difficult to trade in volatile scenarios are a bit off the mark, as our debunking of myths seeks to demonstrate.

We hope this discussion and the charts below help alleviate some concerns around trading fixed income ETFs.

But as always, please reach out to the Vanguard U.S. ETF Capital Markets Team if you would like to discuss anything about ETFs at 484-618-3837.

Debunking bond ETF myths

Myth no. 1

Bond ETF investors won’t be able to find liquidity during market sell-offs.

Reality

Bond ETF trading tends to surge during volatile market periods.

As the figure below shows, trading volume on exchanges for many fixed income ETFs tends to increase during periods of volatility.

The takeaway is that investors who need to buy or sell a fixed income ETF during a turbulent episode find a deeper secondary market than usual—a clear positive.

To put that in perspective, if investors wanted to gain access to a broad portfolio of individual bonds, they would need to find a counterparty to trade each bond, which would be almost impossible and expensive in a volatile market.

With an ETF, liquidity is channeled into one location that easily matches investors that might not meet otherwise. Moreover, as we noted earlier, more than 80% of bond ETF trades occur in the secondary market, which essentially means that when a bond ETF changes hands, the underlying bonds themselves are not trading.

Investors tend to use bond ETFs for liquidity during times of market volatility

Aggregate daily trading volume across all U.S.-listed bond ETFs

Aggregate daily trading volume across all U.S.-listed bond ETFs

Source: Vanguard calculations, based on data from Bloomberg.

Notes: Volume in the secondary market is defined as the aggregate amount traded across all U.S.-listed bond ETFs. The chart includes data from January 3, 2013, through October 31, 2018.

Myth no. 2

Bond ETFs trade with wider bid-ask spreads during market sell-offs.

Reality

Spreads hold up well during market sell-offs and are still narrower than when trading individual bonds directly.

ETF investors benefit from the ability to trade bond portfolios in the equity market ecosystem without incurring the costs of trading the underlying bonds. This helps fixed income investors to avoid transaction costs, and the savings can be substantial.

As we illustrate in the figure below, even on days with the most extreme market movements, the volume-weighted average bid-ask spread of corporate ETFs is as low as a few basis points. That's well below the transaction costs that would be incurred by buying and selling a complete bond portfolio.

Investors who remain leery can protect themselves from wider bid-ask spreads by using limit orders (for a discussion of limit orders, see the spring 2018 issue of ETF Perspectives). Limit orders enable them to set the price at which they are willing to buy or sell an ETF, essentially taking the risk of mispricing off the table.

Transaction costs associated with trading fixed income ETFs remain stable and cheaper than those associated with trading bonds directly

Average daily corporate ETF bid-ask spreads vs. underlying bond bid-ask spreads

Average daily corporate ETF bid-ask spreads vs. underlying bond bid-ask spreads

Source: Vanguard calculations, based on data from Bloomberg and Barclays Point.

Notes: ETF spreads are measured as the volume-weighted bid-ask spread across all corporate ETFs. Barclays LCS is used as the proxy for bond market bid-ask spreads. The performance of the Bloomberg Barclays U.S. Credit Corporate 5–10 Year Total Return Index was used to identify the largest single-day market moves and underlying bond bid-ask spreads. Data include observations between January 3, 2017, and October 31, 2018, from the zero to 99th percentile and exclude holidays.

1 Morningstar, Inc., as of December 31, 2018.

2 Vanguard Investment Strategy Group, 2016. Exchange-traded funds: Clarity amid the clutter.Valley Forge, Pa.: The Vanguard Group.

Check out the next article in the winter 2019 issue of ETF Perspectives.

Fran Kinniry

Designing factor portfolios for your clients

Fran Kinniry, principal and global head of Portfolio Construction, Vanguard Investment Strategy Group, explains how factor-based portfolio construction has many elements, none more important than understanding client goals and appetite for risk.

Notes:

  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • All investing is subject to risk, including possible loss of principal. Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Past performance is no guarantee of future returns.

 

Our insights straight
to your inbox

Our insights straight to your inbox

Receive our latest Advisor's Digest
research
and commentary sent the
first business
morning every week.

A weekly digest of our latest research and commentary. Topics include the economy and markets, portfolio strategy, ETFs, and practice management.


Fund openings/closings, fund manager changes, dividend distributions, webinars, and other events you might want to know about.



Already registered? Log on to
manage your
email subscriptions.