What you need to know about bond ETFs

Sam Benstead looks into how exchange-traded (ETF) bond funds work and the risks of owning them. 

Twenty years since the first bond exchange-traded funds (ETFs) launches, there are now more than 1,800 fixed-income ETFs holding more than $1 trillion (£830 billion) in bonds, according to fund manager BlackRock.

Listed on stock exchanges, ETFs give investors instant access to a diversified portfolio of bonds – but they are more complicated than ETFs that own shares.

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For example, a company can have lots of outstanding bonds, and new bonds are issued more frequently than companies join a stock market index. Moreover, parts of the bond market, such as high-yield bonds, are also far more illiquid than equities.

So, how do bond ETFs overcome these challenges – and are they safe to invest in?

What are bond ETFs?

ETFs are stock market-listed vehicles that own a basket of securities. They allow investors access to many assets by just making one trade.

For example, Vanguard Global Aggregate Bond Ucits ETF owns 8,879 bonds from companies and governments around the world, and trades on the London stock market with the ticker VAGP.

Another popular ETF is the iShares Core £ Corp Bond Ucits ETF, ticker SLXX. Managed by BlackRock, it owns 489 bonds issued in sterling by large “investment grade” companies.

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Because they are on the stock market, where buyers and sellers are connected, there will be “spread” between the bid (selling) and offer (buying) price. The more widely traded an ETF, the lower this spread will be.

Unlike stock market passive funds that tend to buy more of companies as they grow larger (and more successful), bond passive funds have their biggest positions in companies or countries with the most debt.

How do they work?

The complexities of the bond market make bond ETFs different from stock market ETFs. While stock market ETFs generally copy exactly the shares in their benchmark index, bond ETFs tend to “sample” the index in an attempt to replicate its performance without having to copy it exactly.

This is a more cost-efficient and practical method than owning thousands of bonds physically, as some will be difficult to trade cheaply and costs would have to be passed on to investors.

Vanguard says its global bond ETF “invests in a representative sample of bonds included in the index in order to closely match the index’s capital and income return” and “to a lesser extent the fund may invest in similar types of bonds outside the index”.

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BlackRock’s popular iShares Core UK Gilts Ucits ETF and iShares Global Corporate Bond Ucits ETF also uses sampling to get exposure to the price movements of bond indices.

An ETF’s factsheet will have information about how an ETF tracks an index.

What are the risks?

While the price of a bond ETF should normally match the value of its assets, during times of market stress when there are more buyers than sellers, or sellers than buyers, the price of an ETF can diverge from its net asset value (NAV). This means that investors can end up overpaying or underpaying for a bond ETF.

To counter this risk, “authorised participants”, typically large financial institutions such as banks, can improve liquidity by creating or redeeming extra shares in ETFs on behalf of market makers, which broker ETF deals. This process means that in most scenarios the price of an ETF is very close to its underlying value.

However, because bonds are less liquid than stocks, issues sometimes arise. For example, during the March 2020 stock market crash, some ETFs traded at 5% discounts to their NAVs.  

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Wharton Business School professor Yao Zeng notes that “future episodes of ETF-induced liquidity strains seem likely” - so during periods of extreme volatility there could be pricing difficulties for bond ETFs.

City watchdog the Financial Conduct Authority (FCA) notes that high-yield bond ETFs “may be more fragile than the fixed-income ETFs market as a whole” because they are very intensely traded as investors rely on them to access a less liquid part of the bond market.

Should I buy them?

Despite brief periods where bond ETF NAVs and share prices diverged, bond ETFs have proven themselves an efficient and cheap way of owning large baskets of bonds.

Popular bond ETFs traded by interactive investor over the past year include: iShares Core UK Gilts Ucits ETF, iShares USD Treasury Bond 20+yr Uctis ETF, iShares USD Treasury Bond 1 –3yr Ucits ETF, and Vanguard UK Gilt Ucits ETF.

Investors looking for passive exposure to bond markets can also look at open-ended funds, which price their assets daily and do not have a spread between the buying and selling price.

Interactive investor’s Super 60 investment ideas includes the Vanguard Global Bond Index and Vanguard UK Government Bond index.