October 9, 2020 | Expert Perspective
What’s good for the Fed may also be good for investors
Earlier this year, the U.S. Federal Reserve took the unprecedented step of purchasing ETFs that invest in the corporate bond market. It took this step as part of measures intended to support the smooth functioning of bond markets that were seeing heightened, pandemic-linked uncertainty.
Why did the Fed turn to ETFs to do this, and what can investors learn from the Fed's actions?
"The Fed invested in corporate bonds as well as certain bond ETFs to promote liquidity in the corporate credit markets, and investors use these products to help them achieve their investment goals," said Rich Powers, Vanguard head of ETF product management. "But the reasons bond ETFs were able to be used to help stabilize the markets this year and the reasons they help many investors meet their long-term goals are quite similar. Individual investors can take advantage of the same benefits of bond ETFs that the Fed did this year, including diversification, liquidity, and low costs."
How the Fed supported corporate credit markets
When the pandemic reached the United States in March, investor desire for cash rose as market uncertainty increased. This in turn created a liquidity crunch in which even some high-quality fixed income securities experienced liquidity challenges.
The Fed quickly established the Secondary Market Corporate Credit Facility (SMCCF). The SMCCF empowered the Fed to invest in bond ETFs that provide broad exposure to the U.S. investment-grade credit market and U.S. high-yield corporate bonds.
During the second quarter of 2020, the Fed accounted for 9.5% of fixed income ETF net cash flows (about $8 billion of the total $84 billion cash flow). The central bank also bought nearly $2 billion in individual corporate bonds over the same time frame. Its rapid response, combined with other forms of stimulus, helped U.S. corporate bond markets during a period of volatility.
"The Fed's decision to buy corporate bonds was made to improve access to capital for U.S. companies," Mr. Powers said. "And bond ETFs have played an important role in the program—and clearly, they made a difference."
Key takeaways for investors
Mr. Powers noted that the Fed turned to bond ETFs to support corporate bond markets because they serve as an extremely efficient tool for directing capital to a broad swath of bonds—a feature that can also benefit the investor looking to build a long-term portfolio. In general, the benefits of bond ETFs for both the Fed and the investor have to do with diversification, liquidity, and low costs.
A bond ETF can hold hundreds or even thousands of bonds from a range of issuers and provide exposure to the broad spectrum of quality and maturity ranges. For the Fed, this feature allowed it to efficiently support the corporate bond market at large, without having to select individual winners and losers. For investors, the diversification benefits ensure that some corporate bond ETFs can credibly serve as core components of a portfolio, and can provide added peace of mind that there would be little impact on their portfolios if an issuer failed to pay interest or principal.
Liquidity and low cost
Individual bonds trade through dealers and can sometimes be held to maturity, so they can be costly to buy and sell. Because the vast majority of ETF trades are executed on an exchange directly between buyers and sellers, the transaction cost (spread) of a corporate bond ETF tends to be far lower than the average cost of the bonds that it holds.
For example, an investor can access 2,027 bonds in Vanguard Intermediate-Term Corporate Bond ETF (VCIT) for a bid-ask spread of just 0.01% (plus the annual expense ratio of 0.05%)1. In contrast, the same investor would have to pay significantly higher transaction costs of 0.40%—if they purchased this ETF's underlying portfolio of bonds individually.
Vanguard bond ETF spreads versus underlying bonds spreads
ETFs that track the corporate bond markets clearly passed the test this spring during the uncertainty caused by the coronavirus pandemic. In contrast to certain individual bonds that were illiquid, bond ETFs traded at high volume. Because of their diversification benefits, low costs, and high liquidity, the Fed was able to use them to help stabilize markets.
"The key takeaway for investors," Mr. Powers said, "is that they can take advantage of bond ETFs to control costs and establish a diversified core for their bond portfolios."
1 As of August 31, 2020.
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- 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 the possible loss of the money you invest. •
- 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.
- High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings.