Right here’s the difficulty: Throughout instances of utmost market stress, the company bond portion—largely BBB-rated bonds—can see their worth drop sharply and turn out to be illiquid.
Why does this matter for ETFs? Throughout March 2020’s COVID crash, we noticed panicked posts from buyers on Reddit like:
Why did some bond funds crash?
ETFs use an “in-kind” creation/redemption course of to maintain their market value aligned with their web asset worth (NAV). When buyers purchase or promote ETF models, licensed members (APs)—usually giant establishments like banks or market makers—both create new ETF models by buying the underlying bonds or redeem shares by promoting them again into the market.
When the market will get chaotic, over-the-counter traded company bonds can turn out to be much more illiquid than typical—particularly in comparison with shares, which commerce on exchanges, and authorities bonds, which commerce in excessive volumes. This issues as a result of APs depend on sourcing these bonds for in-kind creations and redemptions of ETF shares. When company bonds turn out to be illiquid, it will get tougher to cost them precisely, and the ETF’s market value can deviate considerably from NAV.
Consequently, throughout the top of the March 2020 panic, ZAG’s market value truly traded at an excessive low cost to NAV, as deep as -11.3%.
Should you had been holding ZAG as a protected refuge, and deliberate to purchase the equities dip, this wouldn’t have labored since you would have needed to promote at a steep low cost simply to exit. ZAG wasn’t the low-risk ballast many buyers assumed it could be. Sure, the low cost to NAV reversed shortly inside days, due to fast authorities stimulus that stabilized the market. However the COVID-19 crash was short-lived. Who is aware of what the following disaster will appear like?
If company bond markets freeze up once more, you possibly can see the identical liquidity points. And if that occurs, a broad bond ETF like ZAG might not present the security you’re relying on.
The best way to keep away from a bond-market freeze
Personally, for my bond allocation, I’ve discarded combination bond ETFs like ZAG fully and rely solely on government-issued bonds. For myself, with a U.S. dollar-dominant portfolio, meaning U.S. Treasuries. However for Canadians investing in Canadian {dollars}, a strong various is the iShares Core Canadian Authorities Bond Index ETF (XGB), which tracks the FTSE Canada All Authorities Bond Index.