Why I Don't Buy Corporate Bond ETFs

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Rick Ferri
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Why I Don't Buy Corporate Bond ETFs

Post by Rick Ferri »

Most ETFs track an index, which is fine for stock funds because the underlying stocks in an index tend to be liquid. But following an index doesn't work as well for with bond ETFs because they don't trade as often and liquidity issues can develop in a volatile market. This is particularly true for corporate bond ETFs.

I believe you will find the following article interesting whether even if you don't invest in corporate bond funds. Please see:

Why We Don’t Buy Corporate Bond ETFs

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Re: I Don't Buy Corporate Bond ETFs

Post by Doc »

Unfortunately, corporate bond ETFs often don’t cooperate on the days we are rebalancing. They tend to trade at discount prices to NAV when the stock market falls sharply and we’re selling bond funds, and they can trade at premium prices when stocks are up sharply and we’re buying bond funds. This is a liquidity issue, and it’s unique to bond ETFs.
Rick, please comment on these points.

1) This seems to be an issue more for traders as opposed to investors. As a buy/hold/rebalance investor I don't usually do anything on days that have a high volatility. If I do want to make a trade in such an environment I have a reserve of short Treasuries to use if need be.

2) You make your point most dramatically using high yield and to a lessor extent on long investment grade corporates. Do you consider the price/NAV spread all that significant for short or intermediate investment grade corporate ETFs?

It seems to me that the problem here is not so much the ETFs themselves but the particular sector you are trying to use to rebalance. Rebalancing to/from equity and Treasuries in volatile markets and then rebalancing to/from Treasuries and corporates in calmer markets solves the problem.
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Re: Why I Don't Buy Corporate Bond ETFs

Post by Rick Ferri »

Doc,

Everyone has a different strategy for rebalancing. Ours is to do it when the percent in stocks and bond gets off target by about 10 percent. We used LQD a few years back and found that spreads widened during down markets when we were trying to rebalance. This wasn't due to NAV issues but rather due to temporary liquidity issues in the underlying bonds in LQD that were needed by APs to arbitrage. In a down market, restricted trading is always paid for by the sellers of ETF shares in the form of price discounts. This doesn't happen with open-end funds, so who needs the aggravation and extra cost?

To your point, I've looked at Treasuries ETFs and this doesn't occur because there is ample liquidity in the underlying securities. It just happens in bond sectors that have less trade volume.

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Re: Why I Don't Buy Corporate Bond ETFs

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Rick Ferri wrote:Doc,

Everyone has a different strategy for rebalancing. Ours is to do it when the percent in stocks and bond gets off target by about 10 percent. We used LQD a few years back and found that spreads widened during down markets when we were trying to rebalance. This wasn't due to NAV issues but rather due to temporary liquidity issues in the underlying bonds in LQD that were needed by APs to arbitrage. In a down market, restricted trading is always paid for by the sellers of ETF shares in the form of price discounts. This doesn't happen with open-end funds, so who needs the aggravation and extra cost?

...

Rick Ferri
Agreed. My point is that the 10% rebalance point is somewhat arbitrary or at least "squishy". If my portfolio hit the band mark at a period of high volatility I could just wait a few days. If after a few days the "out of balance" went to 10.5% or even 9.5% I could still react with only minor consequences to my AA.

I don't see any reason to reject the low cost of corporate ETFs simply because of the potential of high spread during periods of high volatility when the high volatility has a low occurrence rate especially when coupled with the probability of hitting my mark at the same time and when I can just avoid the problem by not trading during that time or using other FI sectors to rebalance instead.

I do completely agree with not using high yield or long corporates as a rebalancing tool against equities but that would apply not only to ETFs but other vehicles that represent the same sectors. Arguably these sectors might have a reason to be part of a FI portfolio but lack of correlation with equities would not be high on my list of reasons.
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Re: Why I Don't Buy Corporate Bond ETFs

Post by Robert T »

.
I came to the same conclusion in 2008 - here's the ETF data as at 10-October-2008 - up to a 10% haircut on corporate bond ETFs (relative to an open-ended mutual fund equivalent) sold to rebalance a stock-bond portfolio at that time. For the Total Bond Market Index it was the equivalent of an 8.9 percent haircut if you sold a TBM ETF vs. an open-ended TBM fund - IMO that's a huge difference.

Code: Select all

As at 10-October-08
                                                                    Premium/                                        
Fund Name                            Tikker       NAV     Price    Discount(%)                                                                 
..iShares LB Short-term Treasury      [SHV]     110.31    110.55       0.2
..iShares LB 1-3yr US Treasury        [SHY]      83.82     83.96       0.2
..iShares LB 3-7yr US Treasury        [IEI]     109.34    109.48       0.1
..iShares LB 7-10yr US Treasury       [IEF]      88.13     87.68      -0.5
..iShares LB 20+yr US Treasury        [TLT]      96.18     95.95      -0.2
..iShares LB TIPS                     [TIP]      96.58     95.38      -1.2  
..iShares Gov/Credit                  [GBF]      97.00     93.69      -3.4 
..iShares Intermediate Gov. Credit    [GVI]      98.81     95.71      -3.1
..iShares Aggregate                   [AGG]      96.99     88.40      -8.9
..iShares LB 1-3yr Credit             [CSJ]      95.72     90.66      -5.3
..iShares LB US Intermediate Credit   [CIU]      88.98     85.73      -3.7
..iShares iBoxx $ Inv. Grade          [LQD]      86.96     83.80      -3.6
..iShares LB Credit Bond              [CFT]      86.01     77.23     -10.2
..iShares iBoxx $ HY                  [HYG]      73.99     68.21      -7.8

Source: iShares website
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Re: Why I Don't Buy Corporate Bond ETFs

Post by nisiprius »

Rick, how long has the author of The ETF Book known this? Is this ETF 101, explained in your book? Or is it a recent unpleasant discovery? It does seem as if ETFs aren't quite fully "debugged" yet...
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Re: Why I Don't Buy Corporate Bond ETFs

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Since 2006, that's when we sold out of LQD, before the the financial crisis put an exclamation point behind the issue. I'll have to go back to the book to see if I mentioned it. PS. There are a lot of bugs in ETFs. Remember the flash crash?
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Re: Why I Don't Buy Corporate Bond ETFs

Post by Ozonewanderer »

Rick,
Thanks for the insight. What you say makes sense. I'll have to give my bond ETFs further consideration!
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Re: Why I Don't Buy Corporate Bond ETFs

Post by William Million »

Thanks, good article, and a good reason for purist rebalancers to stay away from corporate bond ETFs. I also don't buy corporate bond ETFs (although I do buy them for stocks).

I suppose there's another side to this, however. Buying a bond ETF at a discount can pay off in the long-run. If an investor is ready to put new money into fixed income and the ETF is selling at a discount, then he could buy it. If there's a premium, go for the fund. Obviously, only a strategy for long-term investors.
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Re: Why I Don't Buy Corporate Bond ETFs

Post by yobria »

Certainly an important point to keep in mind. With traditional mutual funds, you always have someone on the other side of the trade.

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Re: Why I Don't Buy Corporate Bond ETFs

Post by NERD777 »

Rick, BND contains corporate bonds. Would you advocate against owning BND as well based on this?
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Re: Why I Don't Buy Corporate Bond ETFs

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NERD777 wrote:Rick, BND contains corporate bonds. Would you advocate against owning BND as well based on this?
BND has had some pricing issues in the past when markets were stressed. I haven't look at it this year.

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Re: Why I Don't Buy Corporate Bond ETFs

Post by dorokhin »

Having spent a fair amount of time on this issue with vanguard & ishares I think its worthwhile to note that etfs better reflect trading in the underlying bonds. Mutual funds essentially smooth out the pricing, which can be good or bad. If you saw panic in the corp bond market and wanted to buy on a dip, mutual funds would be a terrible way to do it as you would buy into an overstated nav, only to watch it bleed over time to restore parity with the etf. The flip side is that getting out at inflated prices is good if you are selling to buy equities. Of course the remaining holders of the mutual fund suffer as a result as the fund is unable to trade bonds at the level implied by their nav . My best guess is that mutual funds avoid serious performance drag only because people tend to buy bond funds during market panics and thus more assets flow in than out at that overstated nav.
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Re: Why I Don't Buy Corporate Bond ETFs

Post by Rick Ferri »

dorokhin,

I agree that if an investor's strategy was to buy corporate bond funds when markets collapse and liquidity dries up then corporate bond ETFs are an interesting way to potentially capture a liquidity risk premium. The article I wrote stressed the corporate bond ETF disadvantages for buy and hold investors who are selling bond funds and buying stock funds during times of economic stress.

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Re: Why I Don't Buy Corporate Bond ETFs

Post by tarnation »

If the ETF's are trading more than the underlying corporate bonds, couldn't we consider the ETF's better at price discovery and thus the ETF price is the most accurate estimate of value(s)?
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Re: Why I Don't Buy Corporate Bond ETFs

Post by Rick Ferri »

tarnation wrote:If the ETF's are trading more than the underlying corporate bonds, couldn't we consider the ETF's better at price discovery and thus the ETF price is the most accurate estimate of value(s)?
I believe this is a liquidity issue and not a valuation issue. If you absolutely must trade corporate bond ETFs during rapidly moving markets then you're going to pay a premium for that liquidity. Is this extra spread an estimate of fair value for the underlying bonds? I don't believe so because temporary liquidity gaps have nothing to do with the fundamentals of the bond.

Your house isn't worth less because your neighbors have marked down their house to a very discounted price in an attempt to sell immediately to the first bidder. You may decide you're house is worth less in a bad market, but not the ridiculously low level of your neighbors asking price who is trying to sell immediately.

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Re: Why I Don't Buy Corporate Bond ETFs

Post by Rick Ferri »

iShares recently submitted an SEC filing to launch a new AAA-A corporate bond ETF. In the filing, here is what they wrote, exactly as it is writing, and in the all-capital lettering that it is written in:

"The Fund faces numerous market trading risks, including the potential lack of an active market for Fund shares, losses from trading in secondary markets, periods of high volatility and disruption in the creation/redemption process of the Fund. ANY OF THESE FACTORS, AMONG OTHERS, MAY LEAD TO THE FUND’S SHARES TRADING AT A PREMIUM OR DISCOUNT TO NAV."

"Shares of the Fund May Trade at Prices Other Than NAV. Shares of the Fund trade on stock exchanges at prices at, above or below their most recent NAV. The NAV of the Fund is calculated at the end of each business day and fluctuates with changes in the market value of the Fund’s holdings since the most recent calculation. The trading prices of the Fund’s shares fluctuate continuously throughout trading hours based on market supply and demand rather than NAV. The trading prices of the Fund’s shares may deviate significantly from NAV during periods of market volatility. ANY OF THESE FACTORS, AMONG OTHERS, MAY LEAD TO THE FUND’S SHARES TRADING AT A PREMIUM OR DISCOUNT TO NAV. However, because shares can be created and redeemed in Creation Units at NAV (unlike shares of many closed-end funds, which frequently trade at appreciable discounts from, and sometimes at premiums to, their NAVs), BFA believes that large discounts or premiums to the NAV of the Fund are not likely to be sustained over the long-term. While the creation/redemption feature is designed to make it likely that the Fund’s shares normally will trade on stock exchanges at prices close to the Fund’s next calculated NAV, exchange prices are not expected to correlate exactly with the Fund’s NAV due to timing reasons as well as market supply and demand factors. In addition, disruptions to creations and redemptions or extreme market volatility may result in trading prices for shares of the Fund that differ significantly from its NAV."

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Re: Why I Don't Buy Corporate Bond ETFs

Post by Doc »

Rick Ferri wrote:iShares recently submitted an SEC filing to launch a new AAA-A corporate bond ETF.

...

" ... BFA believes that large discounts or premiums to the NAV of the Fund are not likely to be sustained over the long-term. ..."
Thanks Rick,

This is fantastic news. An AA rated intermediate corporate index fund to compete with Vanguard's BBB rated offering and all we need to do to take advantage of it is to not trade during equity market upheavals. Reacting to short term market blips is something most Boogleheads would not do anyway so the caveat is not much of a concern anyway.
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