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Fixed-Income ETFs

In addition to issues that fixed-income indices and index funds face, the exchange-traded fund (ETF) wrapper can create additional problems for fixed-income investors. MFA utilizes ETFs quite a bit, but we rarely use ETFs for fixed-income exposures for several reasons:

Risk

We have witnessed fixed-income ETFs trading at a discount to their net asset value in the past, but the discounts in March 2020 were extreme. One the largest and most liquid bond ETFs, iShare's TLT, traded nearly 5% below its NAV in March. Perhaps even more interesting is Vanguard's ETF BND traded over 6% below what mutual fund shares on the same portfolio traded at (many Vanguard ETFs are a share class of existing mutual fund portfolios, so those ETFs and mutual funds own the same underlying portfolio). Some have argued that ETFs provide better price discovery and that ETF market prices are more accurate than NAV. We are sympathetic to this argument, but our clients prefer to sell at higher prices rather than lower prices (no matter how interesting academic questions about price discovery might be). All else being equal, it is difficult for us to recommend ETFs knowing that this large risk exists (even if it realized infrequently).

The iShares ETF TLT traded nearly 5% below its NAV in March 2020.

ETF shares of a Vanguard portfolio traded over 6% lower than mutual fund shares of the same portfolio.

Tax Efficiency

Of course, a major advantage of ETFs is the tax-efficiency created by "in-kind" creations and redemptions of fund shares. This can provide a material benefit to equity investors who want to minimize turnover for tax purposes, but is of limited benefit to fixed-income investors whose returns consist primarily of interest. Additionally, many fixed-income ETFs utilize create/redeem using cash rather than in-kind securities.

Not all ETFs are created equal, but even the largest and most liquid fixed-income ETFs are not immune from the above issues (of course, the discounts on smaller and less liquid ETFs was much larger than the examples shown above). Every product wrapper possesses a unique set of pros and cons and some suit particular asset classes better than others. We encourage investors to understand these dynamics and evaluate the risks before allocating to fixed-income ETFs.