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.
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.
Want to learn more about ETFs and volatility? See what else Matt has to say.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.
Traditional fixed income ETFs (ETFs) differ from individual bonds in a number of significant ways. ETFs have diversified portfolios, make monthly distributions, and have no set maturity date. The average duration of an ETF does not decline over time. An individual bond is not diversified; it has a set maturity date, and its duration will decline over time. An individual bond will generally make semi-annual distributions, where ETFs make monthly distributions.
Bonds are traded OTC while ETFs trade on an exchange at market price. ETFs have transparent intraday pricing; individual bonds do not.
Carefully consider the iShares Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which may be obtained by calling 1-800- iShares (1-800-474-2737) or by visiting www.iShares.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.
Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. Although market makers will generally take advantage of differences between the NAV and the trading price of iShares Fund shares through arbitrage opportunities, there is no guarantee that they will do so.
Buying and selling shares of ETFs will result in brokerage commissions. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).
©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.
Source: BlackRock Blog ETFs
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