[Editor’s note: The following is the first of a two-part series concluding tomorrow analyzing best practices in using fixed-income exchange-traded funds in the most cost-effective manner in a broadly diversified portfolio.]

While many investors slice and dice the equity market into specific size, style, country and sector allocations—overweighting the parts they like and underweighting the parts they dislike—they’ll often just buy a single broad-based bond fund and be done with it.

That’s woolly thinking, an anachronism from the time plain-vanilla bond funds were the only choice investors had.

Things have changed. Today, investors can tap into everything from international Treasuries to emerging market debt. They can access specific durations in Treasuries, corporates or municipals. They can also buy into Treasury Inflation Protected Securities, convertibles and mortgage-backed securities. Virtually every corner of the fixed-income market has now been covered by exchange-traded funds and index mutual funds.

As a result, investors now have the same opportunity to fine-tune the risk-reward profile on the bond side of their portfolios as they have historically had with equities. If they are only managing the equity side, they’re missing out on significant diversification opportunities.

(This concept is explored in depth in the recently presented IndexUniverse.com webinar, “Advanced Fixed Income: Not Your Grandfather’s Bonds.” The replay is available here.)

Premiums & Discounts

One thing that has prevented many investors from embracing bond ETFs is their reputation for trading at significant premiums and discounts to their underlying net asset value, or NAV. Here’s one chart that illustrates rather dramatically the impact premiums and discounts can have on an ETF:

This chart plots the daily closing premium or discount for the iShares iBoxx High Yield Bond ETF (NYSEArca: HYG) over the nine months ending June 30. It’s a roller coaster. During the heart of the credit crisis, HYG ping-ponged back and forth between a premium and a discount on almost a daily basis. During the big bond run-up at the end of 2008, the premium on HYG stayed over 10% for weeks.

The reason for those enormous moves was simple: The underlying bonds in the high-yield market are illiquid and became more so during the credit crunch, undermining the ETF creation-redemption process. It’s the same problem that plagues some fixed-income ETFs even during “normal” markets, simply because fixed-income markets are less liquid than equities.

The ETF creation-redemption mechanism is what ensures that an ETF’s share price sticks close to the value of its underlying holdings (also known as its NAV).

It works like this. Imagine you have an S&P 500 ETF. If the price of the ETF rises above the value of its underlying holdings, an institutional investor, called an authorized participant, can swoop in and create new shares of the ETF at net asset value and profit from the difference. They do this by buying up all the underlying components in the S&P 500 and delivering them to the ETF issuer; in return, they get shares in the ETF priced at NAV. They can then sell those shares at the inflated market price, notching a profit. This arbitrage mechanism has the salutary effect of pushing the ETF price back in line with its true value.

The process works in reverse if the share price of the ETF falls below the value of its holdings.

For this creation-redemption mechanism to work, however, the underlying securities must be liquid. After all, the APs must be able to buy and sell the underlying securities to execute their arbitrage. In the bond market, that’s not always so easy.

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