Bond ETFs, and by extension open-end bond mutual funds, are not bonds. It seems like an obvious thing to say, but in many cases analysts and investors use them interchangeably. However bonds and bond funds are very different things. A bond ETF usually tracks some an index. That index represents a slice of the bond market by maturity, sector and/or quality. The bond fund manager attempts to track the return on that index. As bonds mature they no longer represent the underlying index and are reinvested into bonds that more closely track the index.
Whereas an individual bond has a set maturity and (generally) fixed coupon. Absent a default that bond will pay its coupon until maturity when an investor will receive his or her principal. Right there we can see the difference between how a pool of bonds would behave differently than an individual bond. There are any number of good reasons why one might choose a bond fund (or ETF) over an individual bond. These include diversification, liquidity and the challenge of investing small dollar amounts in individual bonds.
In a recent post Meir Statman noted how individual bonds, specifically zero coupon bonds, can act as “no mental-loss investments.” Those investors are less likely to sell given fluctuations in interest rates and bond prices. Statman writes:
We hear the importance of the expressive and emotional benefits of no-mental-loss investments in comments about the advantage of buying individual Treasury bonds over mutual funds containing Treasury bonds. Individual bonds have specific maturity dates, such as in three years, while bond mutual funds contain many bonds with varying maturity dates, perhaps some with two years to maturity, some with three, and some with four. Holders of individual bonds have greater no-mental-loss benefits than holders of bond mutual funds since they have the option to wait till the maturity date of each of their individual bonds and receive what they have been promised. In contrast, holders of bond mutual funds have no such option since mutual funds have no maturity dates. The prices of mutual funds are set at the market price at the end of each day, moving up or down. Holders of bond mutual funds are never assured that they will not incur a loss when they sell, no matter how long they wait.
In a recent interview at ETFdb, Matthew Patterson makes a similar point:
ETFdb: Explain the difference in “yield experience” when investing in bond ETFs as compared to investing in individual bonds.
MP: When you buy an individual bond, you have a pretty good idea of what your yield on the investment is going to be. You still have reinvestment risk and default risk of course, but the stream of cash flows you are expected to receive from an individual bond is known in advance, which allows you to calculate an expected yield to maturity at the time of purchase. Even if interest rates dramatically rise and reduce the fair market value of the bond, an investor always has the option of holding the bond to maturity and receiving the benefit of what he originally bargained for.
In contrast, investors have no way of predicting in advance what their expected yield to maturity will be when they purchase a traditional bond mutual fund/ETF. The most obvious reason for this is that traditional bond mutual fund/ETFs have no maturity date. They are designed to operate in perpetuity, so the managers of these funds are constantly buying and selling bonds in order to maintain a constant duration and keep the fund fully invested. This has the perverse effect of maintaining a relatively high sensitivity to interest rate changes even as an investors’ need to liquidate an investment draws nearer. Consequently, investors can actually experience a dramatic decline or increase on the yield of the investment if interest rate moves cause significant changes to the NAV at which investors can liquidate their investment.
Patterson’s firm is behind the launch of BulletShares ETFs. These bond ETFs are designed to have a specific, fixed maturity not unlike an individual bond. One can see how these funds could provide a more defined approach to bond investing. The business challenge is that with a suite of funds any assets garnered are spread over a larger number of funds. It will be interesting to see if they are able to attract investor attention and garner sufficient assets.
That is not to say that traditional bond ETFs do not serve a useful purpose. It has been argued that they provide valuable pricing information to the bond market. Timothy Strauts at Morningstar discusses the ins and outs of bond ETF premiums and discounts and why under certain conditions funds trade away from their NAV. He notes:
In a volatile market, fixed-income ETFs become one of the best price-discovery mechanisms to learn a portfolio’s true value.
The point of all this is not to say one bond investment approach is better than another. The fact that there are a variety of ways of getting bond exposure means that investors need to understand the differences and the advantages/disadvantages of the different approaches. As always, investors need to know what they own.
David Merkel at the Aleph Blog discusses the options available to individual investors interested in bonds.