Why You Should Avoid Bond ETFs

Careful readers may recall that I promised them a post about bond ETFs about a year ago. Here is that post.

Avoiding Bond ETFs

Let's begin with a quote from Bill Bernstein's excellent Rational Expectations. It comes right after a section where he discusses how an ETF is nothing more than a different type of wrapping on a mutual fund.

There are certain circumstances where the [ETF] wrapper does make a difference, the most important area being bonds. I highly recommend that you avoid all ETF bond funds. To understand why, I’ll need to explain some of the trading mechanics involved. An ETF, unlike an open-end fund, trades throughout the day at a discount or premium relative to the net asset value (NAV) of the underlying shares. In most cases, the spread between the two is minimal because shares are both created and liquidated by independent agents: “authorized participants” (AP) who buy up the securities underlying the funds and bundle them into ETF shares that are then delivered to the fund company. The same process also works in reverse to liquidate ETF shares. Were a significant spread to open up between the market price and NAV, the AP, in theory, should simply arbitrage that away at a profit.

This mechanism works well with stocks, which are highly liquid, but not with bonds, which are not. There is, for example, only one commonly traded class of Ford Motor Company stock. By contrast, Ford has a range of bonds of varying issue dates, coupons, and maturities. Since there are so many more individual bonds than stocks, the bonds can be highly illiquid. During a financial disturbance, when liquidity becomes even thinner and most corporate bonds trade only “by appointment,” the AP mechanism fails, often at considerable disadvantage to the shareholder. The open-end fund holder, who can always buy and sell at the 4 p.m. (eastern standard time) NAV, has no such problem.

What he is saying here is that you should avoid bond ETFs, at least for asset classes where liquidity becomes an issue. That definitely includes corporate bonds, and probably municipal bonds. It probably does not, however, including treasuries, either nominal or TIPS, as those tend to remain quite liquid in times of crisis. That's problematic for people who are principally using ETFs in some of their accounts. I use ETFs in my Schwab PCRA 401(k)- it is basically a brokerage window where I can buy any ETF, Schwab ETFs for free, and Vanguard ETFs for $8 or so, and all I have to pay my 401(k) provider is a $200 a year fee instead of 0.2-0.3% of AUM. My current holdings in there are the Vanguard total stock market ETF, the Vanguard emerging markets ETF, the Vanguard international small ETF, and the Schwab TIPS ETF. I don't actually hold corporate or muni bonds in my portfolio, so this advice doesn't really apply to me, but if you do include those asset classes in your investing plan, you might want to consider making sure you hold them in traditional mutual funds and not ETFs.

Bernstein's Bond Recommendations

While we're at it, we might as well take a look at what Bernstein does recommend you do with your bonds. He is firmly in the camp that recommends against taking much risk with your bonds, preferring instead to do it on the equity side. So he basically recommends all treasuries and CDs. He's not dead-set against either corporates or muni bonds (especially muni bonds for taxable investors) but there is definitely a bias against both of those asset classes as you can see here:

A reasonable fixed-income allocation for a largely sheltered portfolio might be equal amounts of CDs and Treasury bills or notes. A largely taxable portfolio might be equal parts munis, CDs, and Treasuries.

If you are going to hold munis and corporates, he recommends a traditional mutual fund.

The only bond funds you should own are open-end municipal and corporate bond funds (to the extent that you do own these two asset classes). The reason for this is simple. Without a great deal of effort and expense, the individual cannot put together a well-diversified low-expense mix of municipal or corporate securities. With munis, the choice is clear: Vanguard offers a wide variety of national and state-specific mutual funds.

However, he feels that:

For the lion’s share of your fixed-income assets, the entire mutual fund structure is, in fact, unnecessary….Unless your account size is tiny, it makes no sense to own a Treasury or government-bond fund, since you can buy these securities at auction and hold them at no cost. The same goes double for TIPS, the main purpose of which is to pay for future real living expenses. You can, with a little effort, tailor a ladder to do so with the proceeds as they mature. If, on the other hand, you hold a TIPS fund, not only do you pay unnecessary fund fees, but there will likely be periods when you will be forced to sell these securities at disadvantageous prices, as happened to many investors in 2008–2009. Much as I love Vanguard’s low fees, there’s almost no reason to pay them even a penny for their TIPS and government-bond funds.

Why I Still Use Funds

So why am I still using bond mutual funds for both my own portfolio and my parents' portfolio? Well, let's consider my fixed income portfolio. First, I've got 5% in P2P loans. The closest thing to a fund charges hedge fund like expense ratios and has a $250K minimum. So that's out. I've got to buy the individual “bonds” either on my own, or as I prefer, with the assistance of an automated service obtained as inexpensively as possible. Next, I've got 10% in the TSP G Fund, a unique fund which gives you treasury returns with money market risk. You can't buy that as an individual bond.

Finally, I've got 10% in TIPS. I've used both the Vanguard TIPS fund and the Schwab TIPS ETF for years. When I started, I certainly had a “tiny” account size. That probably doesn't apply any more as this slice of my asset allocation closes in on $100K. So what does it really cost me to get the convenience of the mutual fund structure? Well, Schwab is charging 7 basis points, no commissions, and a bid-ask spread of 0.08% each way. The Vanguard fund charges either 10 or 20 basis points per year, depending on whether you have more or less than $50K in it. For a $100K allocation, 10 basis points is $100 a year. Not exactly breaking the bank. If I figure my time is worth, after-tax, $100 an hour, I think I'm probably doing okay for now paying Schwab or Vanguard to handle this. In the future, however I will probably eventually start buying individual TIPS with most of that allocation.

Bond Fund Worries

I think most of the worry individual bond investors have about bond funds is a little overblown. The value of your bond goes down (and the yield goes up) when rates rise, whether you own it in a mutual fund or individually. Yes, with an individual bond you are guaranteed to get the original nominal principal back at maturity, but I think that's a relatively minor concern and mostly a psychological benefit. Rising rates are good for bond investors, as long as their investing horizon is longer than the duration of their bonds (and of course assuming no change in the rate of inflation.) Bad behavior of other investors in the fund (or the fund managers) is also minimized with a relatively safe fund like a treasury/TIPS fund at a place like Vanguard, Fidelity, or Schwab. So I would make your decision between a bond fund and individual bonds primarily based on how much hassle you are willing to endure in order to save a few basis points in expenses. For a counterargument, see this guest post from a few months ago, but keep in mind that the author's first criteria for thinking about individual munis is having at least $500K in that asset class, so this probably isn't an issue you need to spend a lot of time worrying about in the first half of your investing career.

What do you think? Do you use bond ETFs? What do you hold in your fixed income allocation? At what dollar amount do you think switching to individual bonds is worth considering? Comment below!