Bond ETF: Definition, Types, and Investment Methods

 

What Is a Bond ETF?

Bond ETFs are exchange-traded funds invested exclusively in bonds. They are passively managed and trade on major exchanges, similar to stock ETFs. The benefits of bond ETFs include market stability, liquidity, transparency, and exposure to various bond categories. Investors can buy bond ETFs with exposure to both U.S. and international markets. The risks of bond ETFs include the potential from a loss of value when interest rates rise.

 

Exploring the Mechanics of Bond ETFs

Bond ETFs trade throughout the day on a centralized exchange, unlike individual bonds, which are sold over the counter by bond brokers. The structure of traditional bonds makes it difficult for investors to find a bond with an attractive price. Bond ETFs avoid this issue by trading on major indexes, such as the New York Stock Exchange (NYSE).

They allow investors to access the bond market as easily and with as much transparency as trading stocks. Bond ETFs are also more liquid than individual bonds and mutual funds, which trade at one price per day after the market closes. And during times of distress, investors can trade a bond portfolio even if the underlying bond market is not functioning well.

Bond ETFs pay monthly interest dividends and annual capital gains dividends, which are taxed as income or capital gains. However, tax efficiency is less significant since capital gains impact bond returns less than stock returns. In addition, bond ETFs are available on a global basis.

U.S. bond ETFs experienced a record-breaking year in 2020. U.S. bond ETFs generated $168 billion in 2020. In October 2019, global bond ETF assets under management topped $1 trillion, and as of June 2023, bond ETFs are one of the fast-growing categories in asset management, at $206 trillion.

 

Different Categories of Bond ETFs

Different types of ETFs cover diverse bond subsectors, such as:

• Treasury Bond ETFs (examples include: SCHO, PLW)
• Corporate Bond ETFs (AGG, LKOR, SPLB)
• Junk Bond ETFs (JNK, HYG)
• International Bond ETFs (BNDX, IYH)
• Floating Rate Bond ETFs (FLTR)
• Convertible Bond ETFs (ICVT)
• Leveraged Bond ETFs (TMF)

 

Pros and Cons of Investing in Bond ETFs

Bond ETFs offer many of the same features of an individual bond, including a regular coupon payment. One of the most significant benefits of owning bonds is the chance to receive fixed payments on a regular schedule. These payments traditionally happen every six months.

Bond ETFs, in contrast, hold assets with different maturity dates. So, at any given time, some bonds in the portfolio may be due for a coupon payment. For this reason, bond ETFs pay interest each month, with the value of the coupon varying from month to month.

The fund’s assets change as bonds are bought and sold when they mature or surpass the target age. The challenge for the architect of a bond ETF is to ensure that it closely tracks its respective index in a cost-effective manner, despite the lack of liquidity in the bond market. Most bonds are held until maturity, so an active secondary market is typically not available for them. This makes it difficult to ensure a bond ETF encompasses enough liquid bonds to track an index. This challenge is bigger for corporate bonds than for government bonds.

Bond ETF providers solve liquidity issues with representative sampling, using only enough large, liquid bonds to mirror an index. Given the liquidity of government bonds, tracking errors will be less of a problem with ETFs that represent government bond indices.

Bond ETFs are a great option to gain exposure to the bond market, but there are some glaring limitations. For one thing, an investor’s initial investment is at greater risk in an ETF than an individual bond. Since a bond ETF never matures, there isn’t a guarantee the principal will be repaid in full. Furthermore, when interest rates rise, it tends to harm the price of the ETF, like an individual bond. As the ETF does not mature, however, it’s difficult to mitigate interest rate risk.

 

Comparing Bond ETFs, Mutual Funds, and Ladders

The decision over whether to purchase a bond fund or a bond ETF usually depends on the investment objective of the investor. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs are a good choice. For the long term, buy-and-hold investors, bond mutual funds, and bond ETFs can meet your needs, but it’s best to do your research as to the holdings in each fund.

Bond ETFs provide transparency by showing fund holdings anytime. To avoid market liquidity issues, consider bond funds, allowing sell-backs to the issuer. As with most investment decisions, it’s important to do your research and speak with your broker or financial advisor.

ETFs provide better liquidity and transparency than passive bond ladders. With instant diversification and constant duration, one trade starts a fixed-income portfolio. This is unlike ladders, which need multiple bond purchases.

One disadvantage of bond ETFs is that they charge an ongoing management fee. While lower spreads on trading bond ETFs help offset this somewhat, the issue will still prevail with a buy-and-hold strategy over the longer term. The initial trading spread advantage of bond ETFs is eroded over time by the annual management fee. The second disadvantage is that there is no flexibility to create something unique for a portfolio. For example, if an investor is looking for a high degree of income or no immediate income at all, bond ETFs may not be the appropriate product.

 

Frequently Asked Questions

Are Bond ETFs the Same As Bonds?

No. ETFs are pooled investments that invest in a range of securities. Investors can buy and sell ETFs like shares of stock on exchanges, and bond ETFs will track the prices of the bond portfolio that it represents.

Are Bond ETFs a Good Investment?

Most investors should have some funds allocated to bonds. Bond ETFs tend to be more liquid and cost-effective than bond mutual funds, and offer diversified bond holdings across a range of bond types, from U.S. Treasuries to junk bonds.

Do Bond ETFs Pay Interest or Dividends to Shareholders?

Bond ETFs pay dividends on a monthly basis based on the interest income earned on the bonds held in the fund’s portfolio.

What Is a Bond ETF Ladder Strategy?

A ladder strategy uses bonds of different maturities to reduce interest rate risk. This can be done with individual bonds, but also with bond ETFs of different duration.

 

The Bottom Line

Bond ETFs offer diversified exposure to a wide range of fixed-income securities with liquidity and transparency, trading similarly to stocks. Investors gain passive exposure to bond indices cost-effectively, but they should be aware of interest rate risks that affect bond ETF prices (in the same way that they affect individual bonds). Bond ETFs provide exposure to Treasury, corporate, junk, and international bonds, providing options for different investment goals. Unlike individual bonds, bond ETFs do not mature, and therefore, they do not guarantee the return of principal. Bond ETFs tend to be more liquid and cost-effective than bond mutual funds but come with ongoing management fees and don’t allow for portfolio customization. When deciding between bond ETFs, mutual funds, and ladders, consider your investment objectives and needs, such as liquidity, type of management style, and preference for transparency.