4 nuances to know about bond ETFs

Since the first fixed income ETFs came to market in 2002, their use has grown significantly over the years. Inflows are accelerating at a rapid pace as it becomes clear that bond ETFs can deliver positive client outcomes.

Opportunities abound for bond ETFs as inflation remains stubborn and the possibility of a recession looms on the horizon. This accelerating growth in assets has been accompanied by increasing trading volumes, as shown in the chart below.

As bond ETF adoption has grown, so too has bond ETF trading

Source: Vanguard Bloomberg data from September 2018 through September 2023.

The reasons for the growing interest in bond ETFs are similar to the reasons why ETFs in general have generated such significant interest in recent years: generally lower costs, efficient implementation of diversification, flexibility tied to their tradability, as well as tax efficiency.

But bond ETFs are different from equity ETFs in a few distinct areas that all advisors and clients should understand. Here are four things you can do to deepen your knowledge of fixed income and fixed income ETFs to better serve your clients.

1. Master an opaque market

Equity and fixed income markets are structured in fundamentally different ways. Whereas equities are traded on public exchanges and have real-time transparency into intraday pricing, individual bonds trade over the counter and can lack pricing transparency.¹  The challenges of getting optimal execution in fixed income markets are exacerbated by the fragmented structure of underlying markets.

In other words, the over-the-counter trading makes it challenging for bond dealers and asset managers to pin down the sourcing of bonds and determine their fair-value prices. For this reason, it's also more challenging to construct fixed income products. This makes it important to evaluate an ETF issuer on its fixed income trading expertise.

Vanguard's approach and large footprint enable operational efficiency and, on a relative basis, a larger number of bonds in its portfolios, allowing for greater coverage across most markets. Additionally, Vanguard's strong reputation with other market participants provides access to favorable new-deal allocations, best possible execution from bond dealers, and participation in primary issuances.

2. Understand the prevalence of index sampling

Unlike most index equity ETFs, which often replicate their benchmarks with great precision, most fixed income products sample their benchmarks heavily. This allows them to avoid the cost and impracticality of full replication in the relatively opaque bond markets. Sampling is important in larger or less liquid parts of the market, such as international fixed income, emerging-market bonds, and corporate credit.

Because of the sampling that prevails in fixed income, it's imperative that asset managers have well-staffed and experienced fixed income teams and a time-tested, sophisticated process. Vanguard, for example, has a dedicated team of credit researchers and traders focusing on matching key benchmark characteristics such as duration, subsector weights, credit quality, and issuer exposure, all in the pursuit of optimal tracking. Our fully integrated but independent risk management group ensures that we balance tight tracking with mitigation of transaction costs.

3. Be mindful of premiums and discounts

For both equity and fixed income ETFs, the quoted market price is typically displayed as the midpoint of the ETF's bid and ask, which reflects the bid and ask prices of the underlying securities. An equity ETF's end-of-day net asset value (NAV) will then be based on the closing prices of the underlying securities.

For a bond ETF, however, the NAV is struck using the bid-side pricing of the underlying securities, as the chart below and on the right shows. That lower NAV means that bond ETFs typically close at a premium on a daily basis.

Because all bond ETFs are priced this way and all bonds exhibit this bid-side pricing as a matter of course, it’s critical to evaluate the consistency of the premium in a given ETF, not just its mere existence, as you seek to determine fair value of a given bond ETF.

Put differently, if a fixed income ETF is trading at a premium, investors might be concerned about a potential "baked in" loss upon sale. However, if the premium is consistent, the risk of that baked-in loss is mitigated.

How equity and bond ETFs are priced

Source: Vanguard.

4. Maximize the tax advantages of bond ETFs

Although bond ETFs are potentially a lower-tax way to own fixed income compared with owning individual bonds, advisors should consider asset location—the type of account the assets are held in—because tax consequences can be distinct with bond ETFs. Bond ETF income will come primarily in the form of dividends, but advisors should be aware that bond ETFs can also generate capital gains.  

Most bond ETFs seek to maintain a specific maturity over time. This means that as bonds roll in and out of the specified maturity bands, portfolio managers must buy and sell to maintain effective tracking. This naturally occurring process can lead to capital gains. Although fixed income ETFs are generally more tax efficient than active fixed income strategies, the ETFs may still pay out capital gains because of their structure.

Takeaways

By suggesting ways to deepen your bond ETF knowledge, we hope to help your due diligence process as you consider integrating or expanding bond ETF use in client portfolios. That way, you can potentially optimize the many benefits ETFs can bring to a portfolio, including lowering costs, relatively easy diversification, flexibility tied to their tradability, and tax efficiency. 

1 Because bond ETFs are listed and traded on stock exchanges, the transparency that equities have accrues to bond ETFs as well. Vanguard's ETF product management team has found that bond ETFs, which are listed on stock exchanges, have become a primary mechanism for price discovery in fixed income markets, especially in volatile markets when liquidity of many types of individual bonds that are traded over the counter dips.

Notes:

• For more information about Vanguard funds or ETF Shares, contact your financial advisor to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• 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. Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
• Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change.  Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal adviser about your individual situation.