The Effect of ETFs on Individual Bonds

The recent LearnBonds article, “Should You Avoid Buying Bonds in LQD? Or Maybe LQD?” brought to readers’ attention a fascinating article by Matt Levine of Dealbreaker, which discussed the idea that bonds underlying ETFs react more dramatically to economic news than bonds that do not underlie ETFs.

Levine cites Goldman Sachs research that showed a three year outperformance of about 4% for bonds underlying the iBoxx $ Liquid Investment Grade Index, compared with bonds not underlying that index.  The aforementioned index is the one tracked by iShares’ popular bond ETF, LQD.  Goldman Sachs also noted that the bonds in that index underperformed those not in the index during the strong pullback in “risk” assets in the second half of 2011.  In other words, bonds in that particular investment grade index experienced more intense movements in price, both up and down, than bonds not a part of the index.

In its article, linked above, LearnBonds offered a couple of actionable ideas related to the Goldman Sachs research.  I would like to expand on the topic and offer some more food for thought.

1. Given that the bonds underlying the iBoxx $ Liquid Investment Grade Index experience more intensity in their price movements, you should not only tend to shy away from them after long periods of spread compression (strength) in corporate bonds, but you should also tend to favor them after long periods of spread widening (weakness) in corporate bonds.  After all, if LQD’s bonds underperform other similarly-rated, non-indexed bonds during periods of “risk off” in financial assets and outperform during periods of “risk on,” you should be buying on underperformance and shying away during outperformance.

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2. Levine explains that the outperformance of the bonds cited in Goldman’s research is “partly explained by just the amount of money flowing into bond ETFs helping the bonds in those ETFs.”  If that is the case for LQD, my hunch is that it is also the case for other popular and large bond ETFs such as HYG and JNK.  To a lesser extent, it may even be true for PHB.

3. After long periods of strength in the corporate bond market, you may find more value in bonds that have not found their way into the portfolios of the larger ETFs.  And after long periods of weakness in corporate bonds, you may find more value in the bonds that have found their way into the portfolios of the larger ETFs.

4. If corporate bonds underlying certain ETFs are more intense in their price movements than those bonds that do not underlie ETFs, it adds an interesting dynamic with respect to corporate bond spreads and credit ratings.  If you are an investor who likes to compare a particular bond’s spread to Treasuries with those of other similarly-rated bonds, you will need to keep in mind whether the bond you are focusing on underlies an ETF.  If it does not, it may skew your findings, as the bond may be trading at a narrower or wider spread to other similarly-rated bonds simply because it is not included in a popular bond ETF, rather than because of a problem with the company’s fundamentals.  It also means that a bond ETF that has, say, an average credit rating of BBB may experience spread contraction similar to non-ETF bonds with higher credit ratings, and it may experience spread widening similar to non-ETF bonds with lower credit ratings.

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5. Before purchasing an individual bond, consider checking whether it is included in the holdings of some of the larger aforementioned bond ETFs.  You can do so by visiting the web page for a particular ETF and finding the link or tab labeled “Holdings” (or something similar).

In the world of commodities, ETFs have certainly played a role in driving investment demand to the underlying commodities.  The SPDR Gold Shares (GLD) is the second largest ETF in the world, with a market capitalization of roughly $72 billion.  Surely, an ETF of this size has had a positive effect on the price of gold over time.  When it comes to stocks, inclusion in an index or being able to garner numerous “Buy” ratings from analysts certainly helps a company’s stock to some extent as institutional demand often follows an index inclusion, and retail demand often follows analyst approval.

If the trend we’ve seen over the past few years of strong inflows into bond funds continues, and the popularity of bond ETFs continues to grow, then the findings outlined by Goldman Sachs should be a positive for individual bond investors.  Those investors will have plenty of opportunities to take advantage of institutional money flows in and out of ETFs moving bonds above and below the prices at which credit quality would dictate the bonds should be trading.

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