Bonds trade over-the-counter (or OTC) where their prices are negotiated privately between buyers and sellers. It can be hard for an investor to find the bonds that they want to buy, and it can be difficult to get a price on bonds they want to sell. It also can be difficult to find information on where bonds are trading in order to get a sense of what a fair buy or sell price should be.
Market Realist – Bond ETFs versus stock ETFs
The above graphs shows the iShares iBoxx High Yield Corporate Bond ETF (HYG) ,the largest corporate bond index, compared with its benchmark, the iBoxx $ Liquid High Yield Index. It shows that the index and the respective ETF move in tandem with little discrepancies. This is due to the two ETFs having liquidity and good amount of participation.
Tracking a bond index can be a challenge, particularly in a highly illiquid sector such as high yield (HYG). The portfolio manager of the ETF is constantly working to reduce portfolio tracking error vs. the fund’s index. And since reputable ETF providers leverage economies of scale and bond desk relationships in order to facilitate trades in illiquid securities, investors actually get exposure to a wider variety of bonds than they would be able to access on their own. Basically, the bond ETF does the legwork of tracking down the bond and ensuring a fair price for you.
Market Realist – Tracking errors in bond ETFs tend to be higher
Tracking error measures the dispersion of an ETF as compared to the underlying benchmark index. Tracking error is affected by various factors including the fees and expenses, the trading and rebalancing costs, a dividends consideration, premium and discounts while trading the ETF, and also tax considerations. In reality, tracking error can’t be zero.
Although bond ETFs in the US are less liquid than the stock ETFs (SPY), they are more liquid than those in some other developed markets (EFA), and much more liquid than those in the emerging markets (EEM).