Exchange-Traded Funds and Fixed Income: Trading and Fees

Individual bonds are traded on over-the-counter markets. Many bonds only trade a few times a year. This creates complications for fixed-income exchange-traded funds, which trade on the exchange thousands of times per day. The ETF providers are able to mitigate most of the issues, but one side effect of the illiquidity of the underlying bonds is the ETF trading at premiums and discounts to net asset value. Premiums and discounts are usually arbitraged away quickly. However, the costs to trade individual fixed-income products are high, so small divergences from NAV should be expected to exist. Also, investors should anticipate a larger degree of tracking error with fixed-income ETFs than with equity-based products.

ETFs usually have lower fees than comparable mutual funds. Low fees are important for all types of investments but especially in fixed income because it is a lower-return asset class.