Investors seeking safety have been pouring cash into bond funds over most of the past year. While that can be a sound if not lucrative strategy when it comes to mutual funds, exchange-traded bond funds bring the risk of limiting gains or magnifying losses.
ETFs are seen as liquid, transparent investment and trading vehicles. But liquidity issues make most bonds a poor fit for ETFs, so an ETF’s share price, dictated by market demand, is often different from its net asset value. As a result, investors often aren’t buying and selling fund shares at levels close to their true value.
The problem is “an inherent flaw in non-Treasury bond ETFs,” said Matt Hougan, managing director of ETF analytics for Index Publications. “The corporate-bond market is notoriously illiquid.”
And given ETFs’ need for liquidity, he said, “it’s a square peg in a round hole.”
The difference between the price and the value of the bond ETF shares is increasingly important after a year that saw the funds rake in assets and ahead of what many analysts expect will be a tough bond market as interest rates start to rise. The likelihood is that many investors bought into the ETFs at a premium and could beat a retreat as the bond market turns, at which point they’ll be selling below NAV.
“If you buy the shares at a premium, you have to be careful you don’t sell it at a discount,” said David Levy, portfolio manager at Austin, Texas-based Kenjol Capital Management.
Take a look at SPDR Barclays Capital High Yield Bond ETF (trading …
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