Here’s the issue: During times of extreme market stress, the corporate bond portion—largely BBB-rated bonds—can see their value drop sharply and become illiquid.
Why does this matter for ETFs? During March 2020’s COVID crash, we saw panicked posts from investors on Reddit like:
Why did some bond funds crash?
ETFs use an “in-kind” creation/redemption process to keep their market price aligned with their net asset value (NAV). When investors buy or sell ETF units, authorized participants (APs)—typically large institutions like banks or market makers—either create new ETF units by purchasing the underlying bonds or redeem shares by selling them back into the market.
When the market gets chaotic, over-the-counter traded corporate bonds can become even more illiquid than usual—especially compared to stocks, which trade on exchanges, and government bonds, which trade in high volumes. This matters because APs rely on sourcing these bonds for in-kind creations and redemptions of ETF shares. When corporate bonds become illiquid, it gets harder to price them accurately, and the ETF’s market price can deviate significantly from NAV.
As a result, during the height of the March 2020 panic, ZAG’s market price actually traded at an extreme discount to NAV, as deep as -11.3%.
Source: ycharts.com
If you were holding ZAG as a safe refuge, and planned to buy the equities dip, this wouldn’t have worked because you would have had to sell at a steep discount just to exit. ZAG wasn’t the low-risk ballast many investors assumed it would be. Yes, the discount to NAV reversed quickly within days, thanks to rapid government stimulus that stabilized the market. But the COVID-19 crash was short-lived. Who knows what the next crisis will look like?
If corporate bond markets freeze up again, you could see the same liquidity issues. And if that happens, a broad bond ETF like ZAG may not provide the safety you’re counting on.
How to avoid a bond-market freeze
Personally, for my bond allocation, I’ve discarded aggregate bond ETFs like ZAG entirely and rely exclusively on government-issued bonds. For myself, with a U.S. dollar-dominant portfolio, that means U.S. Treasuries. But for Canadians investing in Canadian dollars, a solid alternative is the iShares Core Canadian Government Bond Index ETF (XGB), which tracks the FTSE Canada All Government Bond Index.
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