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Nowhere have the transformational changes brought on by the rise of exchange-traded funds been more apparent than in the bond market.

ETFs have expanded the reach of retail investors to previously inaccessible markets by offering a low-cost way to access wide swaths of global fixed income, all in a vehicle that trades and behaves just like a stock.

But there are important differences between fixed-income ETFs and the underlying bonds they hold that might not be so apparent to many ETF converts, according to a recent report from TD Economics.

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And the next sustained nosedive in financial markets could make those differences painfully clear, TD economists Maria Solovieva and Meghan Khosla wrote.

“A prolonged financial stress could result in persistent price differentials between ETFs and their underlying assets. In its extreme, this could undermine investors’ confidence and result in a contagion to other financial asset classes.”

ETFs have by now become a familiar target. They have been accused of distorting financial markets, inflating asset bubbles, subverting traditional value investing and mindlessly plowing trillions into the biggest stocks, fuelling a relentless rise in major equity indexes.

While equity ETFs get most of the hype, their growth rate in Canada has been surpassed over the past 10 years by bond ETFs, which have seen total assets rise to more than $50-billion currently from $1.8-billion in 2007.

Once the purview of more sophisticated investors, hundreds, or even thousands, of bond issues are now available to average investors through just a single ticker.

Canada’s largest bond ETF, the BMO Aggregate Bond Index ETF, offers investors exposure to more than 900 investment grade government and corporate bonds for a management fee of 0.09 per cent. In the United States, iShares Core U.S. Aggregate Bond ETF has attracted more than US$56-billion in assets.

“Rapid market growth is one of the reasons that ETFs have caught the eye of regulators,” the TD report said.

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The concern is the potential for ETF prices to separate from underlying bond values – a disconnect fuelled by the fact that ETFs trade much more actively than do most bonds themselves.

Like mutual funds, ETFs represent a basket of securities. But the two wrappers differ in how they trade – the newer financial innovation trades throughout the day on an exchange, much like a stock.

Bonds themselves tend to be much less active, with even the most liquid among them trading just three or four times a day, while the least liquid might not trade for a month. By contrast, the iShares iBoxx High Yield Corporate Bond ETF trades 32,000 times a day, Blackrock analysts wrote last year.

That discrepancy in liquidity means that ETF pricing can reflect changes that are not yet priced into the underlying bonds. And when the market destabilizes, relatively large differences between the two can open up.

In May, 2013, for example, the U.S. Federal Reserve announced it would begin scaling back the amount of stimulus it was pumping into the economy, which roiled markets in an episode known as the “taper tantrum.”

Over the ensuing four-week period, significant outflows from U.S. fixed-income ETFs saw large swings in pricing compared with the net asset value of the underlying bonds.

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While the two markets reconciled within a month, the taper tantrum emphasized that when the market turns, bond ETFs might not prove to be as liquid as they appear in periods of calm, the TD report said.

“This factor, together with the potential for rapid outflows sparked by a sudden swing in investor sentiment, could act to accentuate asset price declines.”

Concerns such as these tend to elicit some important caveats from ETF analysts and investors.

The first addresses the idea that ETFs have yet to be tested through periods of considerable market stress. “We’ve had a few big tests for ETFs, and they’ve passed with flying colours,” said Tyler Mordy, the president and chief investment officer of Forstrong Global Asset Management.

From the global financial crisis to the 2010 flash crash to the taper tantrum, ETFs have repeatedly weathered unstable conditions, Mr. Mordy said.

Secondly, the occasional ETF disconnect to underlying asset value might alternatively be seen as a healthy trading mechanism, according to Daniel Straus, head of ETF research and strategy at National Bank Financial.

During the financial crisis, for example, the largest U.S. high-yield bond ETFs opened up a discount of 8 per cent or 9 per cent. But many of the underlying bonds themselves went “no bid,” basically meaning nobody wanted to buy them, Mr. Straus said.

“The ETF became the price-discovery mechanism for helping you understand what those assets were now really worth.”

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