This is a problem: During times of extreme market pressure, the portion of corporate bonds (BBB rated bonds) can see their value drop and become non-liquid.
Why is this important for ETFs? In the March 2020 Covid crash, we saw positions where investors panicked on Reddit:
Why did some bond funds collapse?
ETFs use a “physical” creation/redemption process to keep their market price consistent with their net asset value (NAV). When an investor purchases or sells an ETF unit, an authorized participant (APS) (such as a bank or market maker) is often a large institution, whether it is cashing out the market by purchasing basic bonds or exchanging stocks to create new ETF units.
When the market becomes chaotic, over-the-counter trading corporate bonds may become more liquid than usual, especially compared to stocks traded and stocks traded at high volumes. This is important because APS relies on using these bonds for physical creation and redemption of ETF shares. When corporate bonds become non-liquid, it is difficult to accurately price, and the market price of ETFs may deviate significantly from NAV.
As a result, during the peak panic in March 2020, Zag’s market price actually traded in depth at up to -11.3%.
If you use ZAG as a safe haven and plan to buy a stock dip sauce, this won’t work as you will have to sell it at a steep discount to exit. Zag is not the low-risk ballast that many investors think will. Yes, NAV discounts quickly reversed within a few days due to the rapid stimulus of the rapid stabilization of the market. But the 19009 crash was short-lived. Who knows what the next crisis will look like?
If the corporate bond market freezes again, you will see the same liquidity problem. If that happens, a wide range of bond ETFs like ZAG may not provide the security you expect.
How to avoid freezing of bond markets
Personally, for my bond allocation, I completely discarded total bond ETFs like ZAG and rely solely on government-issued bonds. For myself, a dollar-dominated portfolio means our treasury. But for Canadians who invest in Canadian dollars, a reliable option is the Canadian Core Government Bond Index ETF (XGB), which tracks the Canadian FTSE ALL GUAND ALL GOUNTIGHT CANCAL ALL GOUNDICE NOST Bond Index.
