A woman holding a cup of coffee in conversation with another person.

Fixed income investments

4 things to know about bond ETFs & how they work

Overview

Bond ETFs have experienced wide adoption since first hitting the market in 2002, and they have demonstrated continued appeal as their use has accelerated through the years. The bond ETF market today is a rich ecosystem of different industry participants drawn to the investment vehicle for a variety of reasons.

Some of the attributes driving this interest are:

  • Their exchange-traded nature makes them easy to access and trade.
  • They generally have lower expense ratios than other investment products.
  • They offer strong liquidity, transparency, tax-efficiency, and diversification.

Their explosive growth has occurred across varying market environments. But during periods of higher interest rates, fixed income comes into even greater focus for many investment professionals. While most investors have experience using equity ETFs in their portfolios, the more recent emergence of this vehicle trend in fixed income means many investors are looking at passive or active bond ETFs. As you think about introducing bond ETFs into your client’s portfolios, it is important to consider the nuances of this investment offering in the fixed income market and how finding an expert manager can add value.

 

The growth of ETF trading volume reflects accelerating popularity.

A chart showing total secondary trading volume on the y-axis and dates from January 2019 through January 2024 on the x-axis. It shows trading volume, generally, growing with the passage of time.

Source: Vanguard Bloomberg data from January 2019 through March 2024.

Note: Data reflects the ETF notional trading volume of Vanguard fixed income ETFs.

1. The terrain of bond ETFs is complex

Bond markets are inherently more complex than equity markets, which reflects some important differences in the ETFs of each asset class that you and your clients should consider.

The lack of pricing transparency means a need for expertise

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

Knowing this, conducting due diligence on fund options can often benefit you and your clients. At the highest level, seek out bond ETF issuers who appear well positioned to navigate this complex terrain. Some potential indicators may include:

  • An issuer’s trading scale, resources devoted to ongoing management, and access to the new-issue market.
  • An issuer’s approach to trading and portfolio management.
  • An ETF’s degree of replication of its benchmark and the accompanying expectations for performance.
  • An issuer’s track record navigating fixed income markets, particularly during periods of market volatility.

2. Sampling is important in bond ETF benchmark tracking

Unlike many index equity ETFs which often seek to mirror their benchmarks with high degrees of replication, most fixed income ETFs sample their benchmarks heavily. That’s because it’s often costly and impractical to fully replicate the actual holdings of a bond index. The sheer number of issues in target indexes, combined with the infrequency of consistent trading in many issues, contributes to this challenge.

Pay attention to tracking error

Bond ETF fund managers instead use optimized sampling techniques. They track the index the best they can by matching essential risk characteristics such as duration, credit risk, and yield as they seek to mirror the benchmark’s performance. How consistently an ETF tracks—or veers far from—a benchmark can have an outsized impact on potential return because it means a higher risk of being out of sync with the benchmark’s performance.

For index ETFs, the primary objective is to track the performance of a benchmark with as little tracking error as possible. That includes minimizing transaction costs that can erode long-term returns.

 

Sampling a bond index seeks to reduce tracking error without excessive cost

A graph with two y-axes, one on the left and one on the right, connected by an x-axis along the bottom. The left y-axis measures tracking error. The right y-axis measures the cost of investing. The x-axis measures the degree of replication of a bond index. A yellow line that starts high on the left y-axis falls as it moves from left to right. It measures falling tracking error. A green dotted line starts low on the left y-axis and moves upward as is stretches left to right. It measures rising cost.

Source: Vanguard as of December 2023.

It can be beneficial to seek out asset managers with well-staffed and experienced fixed income teams and a time-tested, sophisticated process. Vanguard, for example, employs a deeply skilled team of career fixed income portfolio managers and traders who focus on matching key benchmark risk factors such as duration, subsector weights, credit quality, and issuer exposure, all in the pursuit of optimal tracking.

3. Decoding bond ETF pricing: Premiums and discounts

Premiums and discounts are commonplace with bond ETFs. Understanding their prevalence and patterns over time can be important as you and your clients assess a fund’s potential upside. Identifying bond ETFs that show consistency in premiums can be beneficial because your clients would pay the premium at purchase—and then get it back at sale.

What is a premium?

Across all asset classes, premiums and discounts materialize when ETFs trade at a value higher or lower than that of their underlying securities. As displayed below, this is a natural component of ETF trading and creates an incentive for market participants to transact in the product to bring the ETF price in line with the price of the underlying securities.

A net asset value (NAV), calculated daily, represents an assessed value of the ETF’s underlying securities and helps determine if premiums or discounts are in play at the time of a trade. An ETF, however, transacts at market price, which can sometimes differ from this NAV based on the supply and demand dynamics in the ETF.

 

How an ETF market price stays in line with net asset value

An illustration of fair value shows a pile of variously shaped objects, representing securities, priced at $20. Next to them is a basket of those variously shaped securities being called an ETF and priced at $20. The prices are the same.
An illustration of a premium shows a pile of variously shaped objects, or securities, with a $19.50 price tag, while a basket of securities forming an ETF have a $21.50 price tag. The market maker will realize a $2 profit in that case.
An illustration of a discount shows a pile of variously shaped objects, or securities with a $20.50 price tag, while the objects in a basket of securities forming an ETF are priced at $19.50. In this case, a market maker will realize a $1 profit.

There is some nuance around this dynamic for bond ETFs. An equity ETF's end-of-day NAV is based on the closing prices of the ETF’s underlying securities. For this reason, many equity ETFs generally trade in line with their NAVs.

How equity and bond ETFs are priced

For most bond ETFs, however, the NAV is struck using the bid-side pricing of the underlying securities, as the chart above shows. This bid price represents the price someone would likely receive when liquidating the underlying bonds, which is generally lower than the mid-point. That means bond ETFs typically trade at a premium, or above NAV, on a daily basis. Most bond ETFs are priced this way and all bonds exhibit this bid-side pricing, which could seem to position the investment for a “baked-in” loss at sale.

For this reason, it is important 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. A larger, but stable, premium is often preferable to a lesser, volatile one, as the chart below shows. The more stable the premium, the more likely the ETF is to be trading at that same premium when you ultimately sell the ETF.

An illustration of how ETFs are priced between the ask price and bid-side price.

 

What to look for in premiums/discounts

The volatility of the premium/discount is a large driver of a client’s experience in an ETF. As the case study below shows, many clients may focus on the average premium of a product, but in reality the stability of the premium or discount has a more meaningful impact on a client’s experience. A larger, but stable, premium is often preferable to a lesser, volatile one.

 

Stability as it plays out across two ETFs
 

A line chart representing “ETF A,” which has an average premium of 18 basis points. A line from left to right measures the passage of time from July 2018 through December 2019 and it intersects the y-axis at 0 basis points. It shows that at the buy in 2018, the ETF had a 22-basis-point premium and at the sell in 2019 it had an 18-basis-point premium, or a net of minus-4-basis points.
A line chart representing “ETF B,” which has an average premium of -0.5 basis points. A line from left to right measures the passage of time from July 2018 through December 2019 and it intersects the y-axis at 0 basis points. At the buy in 2018, the ETF had a 64-basis-point premium. At the sell it in 2019, it had a minus-61-basis-point premium, or a net of minus-125 basis points.


Source: Vanguard and Bloomberg.

Note: Two international bond ETFs compared over same time period, with volume weighted average price utilized for evaluation buys and sells on same days.

4. Maximize the tax advantages of bond ETFs

While ETFs are generally a tax-efficient way to access various asset classes, there are distinct things to consider with bond ETFs:

  • Fixed income return, more broadly, is expected to come primarily in the form of income. This is not different for bond ETFs, which means that taxable dividend payments should be the majority of your return.
  • Most bond ETFs seek to maintain a specific maturity over time.

Although fixed income ETFs are generally more tax-efficient than fixed income in other structures, the benefits are typically more muted given the nature of the underlying fixed income market. Consider asset location—the type of taxable or tax-free account the assets are held in—as another tool to maximize tax efficiency.

Explore fixed income subtopics

Fixed income investments

Disclosures and footnotes

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 the liquidity of many types of individual bonds that are traded over the counter dips.

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.

The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about their individual situation before investing in any security.