Different Approaches to Gaining Passive Exposure in the Bond Market

Investors can access bond markets directly or indirectly. Bond markets are often less liquid than stock markets, so indirect methods are commonly used to earn fixed-income returns without incurring the higher costs and commissions associated with direct bond trading.

Pooled Investment Vehicles

Mutual Funds

As with equities, mutual funds are a pooled investment vehicle available to bond market investors. These funds harness economies of scale and offer ongoing exposure to various sectors of the markets. They are often well suited for smaller investors, with the advantage of offering professional management and no need to handle recurring bond expirations, but the drawback of ongoing fees paid for the professional management.

Open-ended Fund

Open-ended funds are very similar to mutual funds in that they are another flavor of pooled investment vehicles. Shares can be redeemed once daily at the net asset value of the underlying securities.

Exchange Traded Fund

Exchange Traded Funds (“ETFs”) are, again, highly similar to mutual funds and open-ended funds. ETFs trade continuously throughout the day on stock exchanges and so offer more flexibility to investors. ETFs tend to have less in terms of sales loads as compared to mutual funds and are often thought to be more tax efficient.

Synthetic Strategies

Total Return Swaps

As the name suggests, total return swaps are a way for portfolio managers to get exposure to the returns of an underlying bond index. Swaps always contain a receiver side and a payer side (“legs”). Say a manager wants a certain portfolio to have an allocation to investment-grade bonds. The manager would offer to pay the return on another index in exchange for receiving the return on the appropriate investment grade bond index. The following is an example of the trading of cash flows that occur:

• Receive return on “Bloomberg Global Investment Grade Corporate Bond Index”.
• Pay return of “LIBOR + 0.25%”.

The calculations of the swap payments and notional principal are covered in more detail elsewhere in the summaries.

Exchange-traded Derivatives

Exchange-traded derivatives typically consist of futures contracts and options. While the bond market has been slower than the equity market in adopting these products, there has been some growth in liquidity for American-style options on interest-rate ETFs, high-yield, and corporate bonds.

Question

Which of the following is a pooled investment vehicle that trades continuously throughout the day?

1. Mutual Funds.
2. Open-ended Funds.
3. ETFs.

Solution

The correct answer is C.

ETFs are investment vehicles that trade on stock exchanges, and they do indeed trade continuously throughout the trading day, just like individual stocks. ETFs have real-time market prices and can be bought or sold at any time when the exchange is open. Therefore, ETFs are the correct answer that fits the description of a pooled investment vehicle that trades continuously throughout the day.

A is incorrect. Mutual funds are pooled investment vehicles that are designed for long-term investors. They do not trade continuously throughout the day. Instead, they are priced once a day at the end of the trading day based on the net asset value (NAV) of the underlying securities. Therefore, mutual funds do not fit the description of an investment vehicle that trades continuously throughout the day.

B is incorrect. Open-ended funds are a type of mutual fund where shares can be bought or sold at their net asset value (NAV) at the end of each trading day. Like traditional mutual funds, they do not trade continuously throughout the day, so they are not the correct answer.

Reading 20: Liability-Driven and Index-Based Strategies

Los 20 (h) Compare alternative methods for establishing bond market exposure passively