Investors seeking lower volatility and increased safety from the stock market have been pouring cash into exchange traded bond funds (ETFs) at a record pace, even with yields at historically low levels. But with banks and brokerage firms more reluctant to hold bond inventories and engage in trading, liquidity of the underlying securities in these funds could be an issue during the next market downturn.

Studies have shown the importance of including fixed income assets when building a diversified investment portfolio. However, some debt securities are less liquid and more difficult to buy or sell than stocks. When fixed income is traded, individual bonds are bought and sold over-the-counter (OTC). In the OTC market, there is no exchange like the New York Stock Exchange, so buyers and sellers have to negotiate a fair price, which makes the experience similar to buying a used car. As a result, bond values can be hard to calculate, and this problem is exacerbated by market stress.

Accurate bond prices are needed to calculate a fund’s net asset value (NAV). Mutual funds and ETF managers rely on bond pricing services, which estimate the value of individual bonds based on reported trades. This method is not 100% accurate, since some bonds do not trade every day, but it provides a best guess based on available data. As an example of the lack of precision, bond prices can vary by as much as one or two percent depending on the pricing service used.

In times of crisis, investors sell whatever is liquid. Bond ETFs could face severe volatility if investors seek to exit their positions simultaneously, especially when the underlying securities such as municipal and corporate bonds may not be trading. In the short-term, the price of the ETF could trade at a discount to the underlying securities.

These are three of the overarching issues we consider when buying a fixed income ETF for clients:

• Premiums/discounts: When you buy or sell a mutual fund, you always transact exactly at the fund’s stated net asset value (NAV). ETF prices, however, are influenced by share supply and demand. Ideally, an ETF should trade at a price close to its NAV and there are mechanisms to keep prices in line, but they are not always perfect. Factors such as market liquidity can cause an ETF to trade higher or lower than its NAV.

• Bid/Ask Spreads: Like stocks, an ETF’s spread is the difference between the price you pay to acquire a security and the price at which you can sell it. For some ETFs, the bid/ask spread can be wide. Moreover, wide swings in the market can cause the prices of an ETF’s underlying securities to move sharply, causing the ETF to have even wider bid-ask spreads.

• In illiquid markets, an ETF’s price may trade at a steep discount to its reported NAV. The spread on the underlying holdings has a big impact on the ETF’s premium or discount. Government bonds tend to be liquid, with narrower spreads making them a better fit for ETFs. Corporate bonds tend to have wider spreads causing the ETFs that own them to have larger premiums and discounts.

Bond ETFs have become very popular with individual investors as they are seen as liquid and transparent investment vehicles. We like the low expense ratios associated with most bond ETFs and the ease of access they provide to complex markets, but investors need to remember that the liquidity of an ETF is only as good as the liquidity of the underlying securities.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.