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Bond mutual fund vs ETF

Updated 22 March 2023

Concern has been raised about the ETF structure for bonds, e.g. William Bernstein:1

I highly recommend that you avoid all ETF bond funds.

An ETF, unlike an open-end fund, trades throughout the day at a discount or premium relative to the net asset value (NAV) of the underlying shares. In most cases, the spread between the two is minimal because shares are both created and liquidated by independent agents: ā€œauthorized participantsā€ (AP) who buy up the securities underlying the funds and bundle them into ETF shares that are then delivered to the fund company. The same process also works in reverse to liquidate ETF shares. Were a significant spread to open up between the market price and NAV, the AP, in theory, should simply arbitrage that away at a profit.

This mechanism works well with stocks, which are highly liquid, but not with bonds, which are not.

During a financial disturbance ... the AP mechanism fails, often at considerable disadvantage to the shareholder. The open-end fund holder, who can always buy and sell at the 4 p.m. (eastern standard time) NAV, has no such problem.

(He actually recommends DIYing your own bond ladder.)

Raymond KerzeĢrho of PWL Capital2 addresses this and related concerns and concludes in favour of bond ETFs. Some noteworthy points:3

While we believe most bond ETFs are structurally safe, caution is always appropriate.

Trade carefully. Acquire bond ETFs at the smallest possible premium above Net Asset Value, and if possible, buy at a discount. Use only limit orders and avoid market orders. Execute trades when the market is stable.

Favor ETFs with a reasonable secondary volume. The creation and redemption of ETFs generate costs, which are borne by the transacting investor. If you have a choice between several bond ETFs that meet your investment objectives, favour the one with the most active secondary volume.

Robin Wigglesworth (Trillions) has the same conviction. Addressing the fall of bond ETF prices below NAV during the COVID panic:4

... everyone tried to sell but almost no one wanted to take the other side.

... the ETF creation-redemption process froze, and the spreads between prices and net assets became chasms.

This is disconcerting. But ETF prices arguably reflected the ā€œrealā€ value of the underlying bonds, not the NAVs.

Moreover, the discounts meant that sellers of the ETF bore the cost of instant liquidity, rather than the remaining investors in the fund. This is a fairer outcome than what happens with traditional bond funds, which often sell their most liquid, higher-quality assets to accommodate outflows, leaving remaining investors holding an inferior portfolio. In extremis, this dynamic can even encourageĀ ā€œrunsā€ on funds, as investors have an incentive to beat others out of the door.

  1. Bernstein, William. Rational Expectations: Asset Allocation for Investing Adults (Investing for Adults Book 4). Chapter 6. Efficient Frontier Publications; 2014. ↩

  2. PWL also counts among its team Benjamin Felix and Cameron Passmore, hosts of the venerable Rational Reminder podcast. ↩

  3. Are Bond ETFs Dangerous? - PWL Capital z:202303221534 ↩

  4. All that drama about fixed-income ETFs was overplayed ↩