How to avoid the pitfalls of bond ETFs

Many investors like to follow share indices. But even all the world's equity markets put together can't match the global bond markets for size. Sure, unless you're an institution, bonds present accessibility problems: they are usually traded privately, away from public exchanges. So pricing is less transparent.

They also trade in "lumpy" amounts that are too large for the average retail trader. But a bond ETF can solve these problems. These ETFs hold a large portfolio of bonds and are traded in real time on an exchange. That makes prices more visible. What's more they can be traded in small sizes. So no wonder these funds are popular. In Europe, bond ETFs have €43bn under management and a 20% market share. In America, of all asset classes they received the largest share of new investor cash in 2009; a trend that's continued this year. Nevertheless, there are potential pitfalls with bond ETFs.

First, an ETF can't magically create liquidity if the underlying assets don't change hands that often. Certain areas of the bond markets suffer from illiquidity and the problem is arguably getting worse. Now even some government bond markets are seeing trading volumes deteriorate. Bond ETFs are therefore prone to trade on premiums or discounts to net asset value (NAV). Large discounts to NAV were seen in corporate bond ETFs in October 2008. Similar problems arose a couple of weeks ago for ETFs tracking US municipal (local government) bonds.

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Second, index construction in bonds does not always make sense from an investment perspective. If you weight bonds by the market size of existing debt, you automatically allocate more money to more indebted issuers. That's a risky strategy. If indices use credit ratings to determine an issuer's eligibility, they are relying on organisations whose credibility was battered by the credit crunch. However, new bond indices that address some of these concerns are now appearing it's worth keeping an eye out for them.

Finally, be aware that bond ETFs can vary greatly in their sensitivity to interest-rate changes. The greater the interest-rate sensitivity ('duration') of a bond portfolio, the greater the potential for capital gains or losses. So, if you're buying bond ETFs for income, as many people do, talk to your broker about how much you might lose if yields rise.

Paul Amery edits www.indexuniverse.eu