Previously, I provided a primer for you on exchange traded fund (ETF) mechanics. Today I wanted to take things a step further and explain the basics of bond ETFs. As a reminder, an ETF is a fund that trades on an exchange like a stock. It bundles a portfolio of stocks or bonds into a single, simple package. Shares of that package are then traded on an exchange just like the stock of an individual company. While the investing in individual stocks to create an equity ETF is pretty straightforward, bond ETFs may be less familiar to some investors. But as someone who lives and breathes ETFs every day, it’s one of my favorite topics.
From Bond Market to Bond ETF
Bond ETFs have been around for more than a decade. Before their inception in 2002, bond markets were not easily accessible to everyday investors. That’s because bonds trade over-the-counter (OTC): Buyers and sellers negotiate bond prices privately, meaning it can be tough for an investor to find the bonds they want to buy, or get a price for the bonds they want to sell. An investor may have to go from dealer to dealer to find the bonds he’s looking for, in the quantity he wants, and at the price he’s willing to pay. And when he does find the price he wants, it can be difficult to know if another dealer would have provided a better price. The process starts all over again when the investor tries to sell the bond. Bond ETFs can help investors assess, price, and trade bond investments, ultimately simplifying access to the bond market.
So How Does it Work?
A bond ETF portfolio manager (PM) is responsible for managing the ETF on behalf of investors. The PM will need to navigate the OTC bond market to rebalance the portfolio and keep it in line with its investment objectives. The ETF is made available on an exchange, where its market price is visible. This price transparency is very important as it allows investors to see the best price available in the market to either buy or sell at any time.
By bringing the bond world onto an exchange, ETFs provide another place for investors to access the fixed income markets. This potentially provides investors with another key benefit: additional liquidity. We think of liquidity as the ease with which investors can quickly buy or sell, at an agreed upon price, in a given market. For example, a home is a relatively illiquid investment. You can get an estimate on its price, but until the sale is made and you have a check in your hand, it’s unclear how much you’ll get for selling it. On the other hand, the price of a bond ETF can be observed on the exchange, and an investor can use that information to decide whether to buy or sell. And as more investors participate in the bond ETF market, the more efficient trading can become, and the greater the potential liquidity.
Ultimately, ETFs are changing the way we invest in bonds, bringing simplified access, transparent pricing, and potential additional liquidity to the market, benefitting a range of investors.
See more from Matt: Understanding Bond ETFs.