What happens to bond ETFs in stressed markets?

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Since their introduction more than a decade ago, bond ETFs have become an important investment tool. Interestingly, their value is most obvious during times of bond market stress. Matt Tucker explains.

After going over some of the basics of exchange traded funds (ETFs) and specifically, bond ETFs, I am going to dive a little deeper today and look at how bond ETFs fare when the markets are stressed.

Before I start, here is a quick recap: An ETF is a fund that trades on an exchange like a stock. A bond ETF bundles a portfolio of bonds into a single, simple package. Shares of that “package” are then traded on a stock exchange. Because a bond ETF is simply made up of a collection of bonds, its market price will typically fluctuate along with the collective price of its underlying securities. So, when buyers push up the prices of bonds, the prices of bond ETFs should rise. And when sellers push down the prices of bonds, the prices of bond ETFs should fall as well.

When supply and demand are out of whack

On most days, movements in bond prices are fairly contained as the number of buyers and sellers are relatively balanced. But sometimes markets experience stress. Bad news during periods of uncertainty could lead many investors to want to sell at the same time, and bond prices may move sharply in a single day. As prices in the bond market fall quickly, so too will the price of a bond ETF, reflecting the changing value of the securities it holds. However, because a bond and a bond ETF trade in distinct markets, an investor’s ability to quickly sell these two securities can be very different.

Too many for sale signs

In the bond market, investors buy and sell “over the counter,” — directly with bond dealers. Every transaction is negotiated one-on-one in order to reach an agreement on price. But when the market is in distress and most investors are looking to sell, it may be hard to find a bond dealer who is willing to buy, and even more difficult to agree on a fair price. Bond trading could slow dramatically as a result.

Managing liquidity

Things may be easier with bond ETFs. The stock exchange, where the bond ETF is traded, brings buyers and sellers together in one place. Prices for bond ETFs are available in real-time throughout the trading day, and are visible to everyone. In volatile markets, centralized trading and transparent pricing can bring price clarity that helps connect buyers with sellers quickly. This may make trading in bond ETFs less complicated and more efficient than trading individual bonds. In fact, historically, when bond markets have become overwhelmed and trading has slowed, the amount of trading in bond ETFs has actually increased—sometimes substantially—providing investors with an additional source of liquidity when they need it most.

Since their introduction in 2002, bond ETFs have weathered numerous periods of volatility. While bond ETF prices have swung, reflecting the tough conditions in the bond market, they have become an important tool that allows investors to observe market movements in real-time and, to transact, even when the bond market is stressed.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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