Bonds observations from Vanguard

[veremchuka]

https://personal.vanguard.com/us/insights/article/volpert-bonds-09042012?SYND=RSS&Channel=AN

Ken Volpert, head of Vanguard's Taxable Bond Group, made some interesting observations. I'm not sure whether these comments apply to only taxable accounts but I suspect not. The italics are mine for emphasis.

About high yield bonds:

We are less optimistic about high-yield strategies, which will show volatility similar to stocks if we are facing a recession or a breakup of the euro. I know these products are popular with advisors. So I would caution them to consider investing in mutual funds instead of ETFs for this sector. The reason is the liquidity of the underlying bonds. When high-yield bonds are doing well and cash flow is positive, investors in ETFs are typically paying a significant premium over NAV in the less transparent, less liquid market for below-investment-grade bonds. When high-yield bonds are declining and cash flow reverses, investors could face not only the disappearance of that premium, but also a discount to NAV when selling the ETF. For ETF investors it’s really important in this segment of the market not to trade with the crowd because the crowd will bear the brunt of these premium-to-discount swings.

and for MBS:

The prices for MBS are getting bid up because of the desire for yields above those on Treasuries. This has reduced the yields on MBS, but there is still a pickup over Treasuries. We also anticipate a boon for this segment if the Federal Reserve buys MBS in the next round of quantitative easing.

 

[mathjak107]

When the difference between the etf price and the basket of what it holds differs arbitragers usually buy one and sell
the other bringing prices back together.

 

[photoguy]

There are problems with the arbitrage mechanism that makes it less efficient for high yield bonds:

Why Bond ETFs Often Do Not Track their NAVLearnBonds.com

Basically, unlike stocks, many of the HY holdings do not trade as actively and hence it's harder to price and resell them.

 

[LOL!]

Easy solution: Don't invest in below-investment-grade bonds if you use ETFs.

 

[mathjak107]

There are problems with the arbitrage mechanism that makes it less efficient for high yield bonds:

Why Bond ETFs Often Do Not Track their NAVLearnBonds.com

Basically, unlike stocks, many of the HY holdings do not trade as actively and hence it's harder to price and resell them.

thanks for the article, it does make sense.