Bond ETFs are NOT Bond Replacements
Last week we did a post outlining the basics of bonds. (see it here)
This sets us up for the post this week on Bond ETFs. Now most people set some allocation of their 401k to whatever intermediate bond fund ETF their company offers and that is the extent they think about their bond allocation. Maybe you have a target date fund that is allocating a portion of the money to the bond ETF for you. Or maybe you are doing your own 60/40 portfolio with Bond ETFs…
The point is, very few people own bonds and a lot of people own bond ETFs. This may seem like an insignificant nuance. People often conflate bond ETFs with their more widely talked about cousins, stock ETFs.
Well we are here to tell you there is a lot of reasons why owning a bond ETF is NOT the same as owning bonds. And a bond ETF is NOT equivalent to stock ETFs.
In fact, a bond ETF could theoretically always have a negative total return, even if individual bonds have positive returns over the period.
Basic Bond Market Background
First, you need to understand that the bond market is massive. It is estimated that the US bond market is over twice as large as the stock market by market cap.
Add to the fact that each bond issuance is its own unique security. A 5% coupon bond issued in 2020 with a 5 year maturity from company A is different from a 5% coupon bond issued in 2022 from the same company. Each issuance is non-fungible. They will vary by:
maturity date
coupon
covenants (ie- protections and agreements)
seniority (ie- where they fall in bankruptcy)
collateralization (ie- are they secured with some physical asset backing them or unsecured)
callability/convertibility
Ratings
etc.
Compare this to stocks - when a company issues new shares of stock, they are indistinguishable from the older shares.
So not only is the market cap of the bond market significantly larger, but the number of assets out there is multitudes higher as each company has numerous cohorts of bonds out there.
Additionally, bonds tend to have material bid-ask spreads. The bond market is still traded largely with phone calls and a physical market maker buying & selling bonds. This leads to a bigger bid-ask than in the more automated stock market.
The other big call out is the ratings on the debt issuance. Each bond issuance gets rated by rating agencies to measure the ‘safety’ of the bonds. Different rating agencies have different rating systems, but AAA is the safest.
How Bond ETFs Work
Bond ETFs come in many flavors, but for the most part they will have some mandate for what they can buy. “This fund only invests in investment grade bonds with maturities 5-10 years” for example.
It is important to know if your ETF has strict or loose mandates. If the fund is unable to hold bonds <5 yrs, >10 yrs, or below investment grade, this means the fund is a forced seller. As time passes, if any holdings in the fund have their maturity move to less than 5 years, it needs to be sold. Or if a bond gets down graded to below investment grade, it needs to be sold.
Being a forced seller is never good. For example, when a bond gets downgraded to below investment grade, the risk premia on it goes up meaning the price of the bond goes down. And since many funds can’t hold below investment grade bonds, there tends to be a large sell-off. Selling low is not a good strategy, but your bond ETF is forced to do it.
We will touch back to the fund mandate throughout this post, but wanted to give a little background upfront.