As investors seek to add diversification to their portfolios and remain wary of the overall economic health of the US, some have turned to bond exchange traded funds (ETFs) to complete their portfolios and for good reason. These ETFs often offer low cost alternatives, asset allocation and exposure to hard-to-reach markets and sectors; however, they carry unique risks as well.
In addition to carrying the risk of default and interest-rate risk, which all nearly all bonds carry, bond ETFs carry the risk of having a wide spread, deviating from its net asset value (NAV) and tracking error.
An inherent characteristic of bond ETFs, their ability to be traded intraday, makes them susceptible to carrying a wide bid/ask spread, which is the difference between the amount that market makers are willing to sell an ETF share for and the amount that they are willing to buy one for. In general, bond ETFs that have relatively low trading volumes are the most prone to this issue.
Another risk to be mindful of with bond ETFs is a deviation of the ETF from its net-asset-value (NAV). Several bond ETFs have traded at prices above their NAV as investors have poured assets into these ETFs while the underlying bonds have been more expensive to trade. The opposite is also true, that as asset flow out of the bond ETF at an exceptional high rate, they could trade below the NAV of their underlying index. This risk is more commonly seen in bonds that are hard to trade, such as high-yield bonds and some international bonds, than in traditional bonds.
Lastly, it is important to keep in mind that tracking errors between an ETF and the underlying index it seeks to track could form. ETFs are designed to mimic an index and sometimes cannot do so strict SEC diversification requirements that would limit holdings in such a way that holdings in the ETF would deviate from those of the index, or index optimization by the ETF rather than fully replicating the holdings of the index. “Optimization” might be used when full replication of an index is not possible (e.g. limitation on position concentration or position size, limited number of shares available on one or more index components).
Although these risks in bond ETFs are there, they are still excellent tools in adding diversification and gaining access to hard to reach markets, like some international bonds.