Raymond Kerzérho March 24, 2020 Market Research Personal Wealth The Recent Volatility in Bond ETFs Explained PWL invests in fixed income markets with high-quality bond ETFs and/or mutual funds for our clients’ portfolios. The bond ETFs and mutual funds generally act as a counterweight to the greater risk of equity investments. However, bond ETFs have been volatile in recent days, while bond mutual funds have been comparatively more stable. To illustrate this point, let’s look at the price fluctuations of the iShares Core Canadian Universe Bond Index ETF and the TD Canadian Bond Index Fund–which hold almost identical portfolios—on March 18, 19 and 20: Mutual Fund / ETF % Price Change on March 18 % Price Change on March 19 % Price Change on March 20 iShares Core Canadian Universe Bond Index ETF -5.8% +4.8% +1.1% TD Canadian Bond Index Mutual Fund -1.2% +0.3% +0.6% How can two investment vehicles holding nearly identical portfolios behave so differently? The reason is that the quoted values of mutual funds and ETFs are set using different methodologies. Bond ETF closing quotes are observed from the last trade of the day on the exchange. Bond mutual fund closing quotes are based on a mathematical model that values the individual bonds underlying the fund. When markets are under high stress, the quotes for bond ETFs are very sensitive to this stress, while the quotes for mutual funds are far less so. When the market is stable, these two quotes are similar, but when the market is highly volatile, these two quotes sometimes diverge substantially. Bond Funds Explained Bond investing is easier to understand if we think of it as a play with three main characters: individual bonds, bond ETFs and bond mutual funds. The market for individual bonds is the largest financial market in the world. At the end of 2019, the value of all bonds outstanding worldwide was roughly 1½ times that of the global equity market. The bond market has a wrinkle though: unlike in the equity market, trades are not executed on a centralized marketplace; rather, they are negotiated directly from trader to trader. This causes a dispersion of information. During normal times, bond values do not fluctuate much, and therefore this dispersion of information is not a problem. But when bonds become volatile, traders may find it challenging to value the less frequently traded issues. Bond ETF shares are participations in a portfolio of individual bonds that trade on an exchange. Bond ETFs have a life of their own: their shares trade through the day; buyers and sellers agree on a price for the shares; and transactions get executed. The price on the last transaction at the end of the day is the closing price of the ETF. Bond mutual fund shares are also a participation in a portfolio of individual bonds. But, in this case, investors can only buy and sell shares through a mutual fund company. The mutual fund company only acts as an intermediary in the transaction and it must hire a valuation firm to assess the worth of the portfolio (based on a mathematical model, as mentioned above). This valuation, for the total portfolio of individual bonds divided by the number of shares of the mutual fund, results in the Net Asset Value of the shares. Investment Takeaways PWL invests in high-quality bond mutual funds and ETFs for client portfolios. It is normal for bond ETFs and mutual funds to behave differently during episodes of high volatility in the market for individual bonds. Bond ETF prices are more sensitive to market stress than those of bond mutual funds, because of a difference in the valuation methodology. This high level of stress may last a few weeks or months, but markets will eventually stabilize.[i] [i] We suggest you read this paper to learn more about bonds. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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