ETFs offer no haven during a stampede

Exchange-traded funds' liquidity could be a double-edged sword
MAR 17, 2013
By  JKEPHART
Investors looking for a low-cost and liquid way to access the fixed-income market have been piling into exchange-traded-bond funds, but experts urge caution. Bond ETF users tout the ease with which they can get into and out of bond markets as the top reason for using the products. In fact, more than 70% of financial advisers cited liquidity as the biggest advantage that bond ETFs have over individual bonds or bond mutual funds, according to a survey by Guggenheim Investments last fall. Just 16% cited lower costs. But that liquidity could be a double-edged sword, said Todd Rosenbluth, director of ETF research at S&P Capital IQ. Fixed-income ETFs are only as liquid as their underlying bonds. Once investors start moving out the bond spectrum into more-illiquid securities such as high-yield bonds and municipal bonds, the ETF's share price can dislocate from its net asset value in times of extreme inflows or outflows. When the ETFs are experiencing large inflows, they tend to trade at a premium, which means that investors are buying $1 worth of bonds for slightly more than that, and during outflows, they trade at a discount, meaning that investors who are leaving aren't getting their full $1 of NAV back. The $15 billion iShares iBoxx High Yield Corporate Bond ETF (HYG), the largest high-yield-bond ETF, has seen its share price veer as far as 2.88% ahead of its NAV and 1.76% below, according to Morningstar Inc. This, however, allows advisers to see where the ETF is trading relative to its NAV before making a trade, so if they aren't following the crowd, they can use it to their advantage. “It's all about awareness,” Mr. Rosenbluth said. Assets in fixed-income ETFs, while still dwarfed by those of mutual funds, have more than quadrupled to $255 billion, from $56 billion at the end of 2008, making them the fastest-growing bond investment over the past four years. Meanwhile, bond mutual fund assets have doubled to more than $2 trillion.

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