In my Welcome to the World of Fixed Income ETFs blog last month, I touched on the differences between how individual bonds and bond ETFs trade. For me the differences between these markets, and what it means for investors to put bonds onto an exchange through an ETF, are some of the most interesting things about the ETF market. To explain the point it is helpful to look at an illustration:

The diagram on the left is a simplified example of how the bond market works. Individual bonds are primarily traded “over-the-counter” or OTC. Instead of trading on a formal exchange like the NYSE, an OTC market is decentralized, and buyers and sellers of individual bonds must negotiate one-on-one to reach a price.

How does that happen? Let’s walk through an example. Say Customer A wants to buy a bond. Customer A would need to call Broker A to ask if Broker A has the bond available for sale. If she does, Customer A would then need to ask at which price she would be willing to sell it. If Customer A is unsatisfied with the price or Broker A does not hold the bond, Customer A would then need to call Broker B and so on and so on until Customer A could find both the bond and an agreeable price. And in practice Customer A is going to want to get prices from a couple of different brokers in an effort to get a lower price. That’s a lot of phone calls and negotiation.

Meanwhile, Broker B is taking calls from other customers like Customer B. Customer A has no way of knowing that Customer B is calling Broker B. In this OTC market where trading is not centralized, Customer A has no way of seeing the price Customer B is getting from Broker B. This can lead to large disparities in the prices paid by different investors.  Broker B could sell the same bond to both Customers A and B at the same time — yet at different prices.

Now, let’s switch over to the equity markets and the right-hand side of the illustration.

Unlike individual bonds, bond ETFs trade on an exchange, like the NYSE. The exchange is a centralized trading system that connects buyers and sellers, and prices are quoted continually throughout the trading day. An order book lists buy and sell orders, allowing investors to see in real time the price and demand for an ETF. This transparency gives participants view into how the overall market is valuing an ETF, which in turn can help to narrow spreads and lower transaction costs for investors. If Customers A and B both go to buy the same bond ETF they have largely the same access to inventory and price information, and their execution prices, assuming they are similar trade sizes, are likely  to be similar.

For me, this discussion captures the core benefit of fixed income ETFs for most investors. You can see a variety of fixed income markets trading in real-time on the exchange, everything from Treasuries to corporate bonds to emerging market debt.   You can observe the bid and offer prices where the funds trade to get a sense of the transaction costs you might incur. And ETFs trade on an exchange, so you do not need to call your broker to inquire about inventory. Transparency, efficiency, and liquidity, are all important attributes in the fixed income market where, traditionally, these attributes are hard to come by. The fixed income ETF democratizes the bond market, providing investors with similar market information and access.

Bonds and bond funds will decrease in value as interest rates rise.

Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units.  There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.  Buying and selling iShares funds will result in brokerage commissions.