Bond exchange-traded funds (ETFs) are exchange-traded funds (ETFs) that invest solely in bonds. These are comparable to bond mutual funds in that they hold a portfolio of bonds with various strategies—from US Treasuries to high yields—and holding periods (long and short).
Bond ETFs are comparable to stock ETFs in that they are passively managed and traded on major stock exchanges. Adding liquidity and transparency during times of stress helps to maintain market stability.
Bond ETFs: Can They Lose Money?
- Market transparency is lacking. Bonds are traded over-the-counter (OTC), which means they are not traded on a single exchange and have no official agreed-upon price. The market is complicated, and investors may find that different brokers offer vastly different prices for the same bond.
- High profit margins. Broker markups on bond prices can be significant, especially for smaller investors; according to one US government research, municipal bond markups can reach 2.5 percent. The cost of investing in individual bonds can quickly pile up due to markups, bid/ask gaps, and the price of the bonds themselves.
- Liquidity issues. Liquidity of bonds varies greatly. Some bonds are traded daily, while others are traded weekly or even monthly, and this is when markets are at their best. During times of market turmoil, some bonds may cease to trade entirely.
A bond ETF is a bond investment in the form of a stock. A bond ETF attempts to replicate the performance of a bond index. Despite the fact that these securities only contain bonds, they trade on an exchange like stocks, giving them some appealing equity-like characteristics.
Bonds and bond ETFs may have the same underlying investments, however bond ETFs’ behavior is affected by exchange trading in numerous ways:
- Bond ETFs do not have a maturity date. Individual bonds have a definite, unchanging maturity date when investors receive their money back; each day invested brings that day closer. Bond ETFs, on the other hand, maintain a constant maturity, which is the weighted average of all the bonds in the portfolio’s maturities. Some of these bonds may be expiring or leaving the age range that a bond ETF is targeting at any given time (e.g., a one- to three-year Treasury bond ETF kicks out all bonds with less than 12 months to maturity). As a result, fresh bonds are regularly purchased and sold in order to maintain the portfolio’s maturity.
- Even in illiquid markets, bond ETFs are liquid. Single bonds have a wide range of tradability. Some issues are traded on a daily basis, while others are only traded once a month. They may not trade at all during times of stress. Bond ETFs, on the other hand, trade on an exchange, which means they can be purchased and sold at any time during market hours, even if the underlying bonds aren’t trading.
This has real-world ramifications. According to one source, high-yield corporate bonds trade on less than half of the days each month on average; on the other hand, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) trades millions of shares per day.
- Bond ETFs pay a monthly dividend. One of the most appealing features of bonds is that they pay out interest to investors on a regular basis. These coupon payments are usually made every six months. Bond ETFs, on the other hand, hold a variety of issues at once, and some of the bonds in the portfolio may be paying their coupons at any one time. As a result, bond ETFs often pay interest monthly rather than semiannually, and the amount paid can fluctuate from month to month.
- Diversification. You may own hundreds, even thousands, of bonds in an index with an ETF for a fraction of the cost of buying each issue individually. At retail prices, it’s institutional-style diversification.
- Trading convenience. There’s no need to sift through the murky OTC markets to argue over rates. With the click of a button, you may purchase and sell bond ETFs from your regular brokerage account.
- Bond ETFs can be bought and sold at any time during the trading day, even in foreign or smaller markets where individual securities may trade infrequently.
- Transparency in pricing. There’s no need to guess how much your bond ETF is worth because ETF values are published openly on the market and updated every 15 seconds during the trading day.
- More consistent revenue. Instead of six-monthly coupon payments, bond ETFs often pay interest monthly. Monthly payments provide bond ETF holders with a more consistent income stream to spend or reinvest, even if the value varies from month to month.
- There’s no assurance that you’ll get your money back. Bond ETFs never mature, so they can’t provide the same level of security for your initial investment as actual bonds may. To put it another way, there’s no guarantee that you’ll get your money back at some point in the future.
Some ETF providers, however, have recently began creating ETFs with defined maturity dates, which hold each bond until it expires and then disperse the proceeds once all bonds have matured. Under its BulletShares brand, Guggenheim offers 16 investment-grade and high-yield corporate bond target-maturity-date ETFs with maturities ranging from 2017 to 2018; iShares offers six target-maturity-date municipal ETFs. (See “I Love BulletShares ETFs” for more information.)
- If interest rates rise, you may lose money. Rates of interest fluctuate throughout time. Bonds’ value may fall as a result of this, and selling them could result in a loss on your initial investment. Individual bonds allow you to reduce risk by simply holding on to them until they mature, at which point you will be paid their full face value. However, because bond ETFs don’t mature, there’s little you can do to avoid the pain of rising rates.
Individual bonds are out of reach for the majority of investors. Even if it weren’t, bond ETFs provide a level of diversification, liquidity, and price transparency that single bonds can’t match, plus intraday tradability and more regular income payouts. Bond ETFs may come with some added risks, but for the ordinary investor, they’re arguably a better and more accessible option.
Are bond ETFs a good investment?
The decision of whether to buy a bond fund or a bond ETF is usually based on the investor’s investing goals. Bond mutual funds provide more options if you desire active management. Bond ETFs are a smart alternative if you plan to buy and sell regularly. Bond mutual funds and bond ETFs can suit the needs of long-term, buy-and-hold investors, but it’s best to conduct your homework on the holdings in each fund.
If transparency is essential to you, bond ETFs allow you to see the fund’s holdings at any time. If you’re worried about not being able to sell your ETF because there aren’t enough buyers in the market, a bond fund can be a better option because you can sell your holdings back to the fund issuer. It’s crucial to conduct your research and consult with your broker or financial advisor before making any investment decisions.
An ETF has advantages over a passively held bond ladder in terms of liquidity and transparency. Bond ETFs provide rapid diversification and a consistent duration, requiring only one move to get a fixed-income portfolio up and running. This luxury is not available with a bond ladder, which requires the purchase of individual bonds.
Bond ETFs have the disadvantage of charging an ongoing management fee. While decreasing spreads on trading bond ETFs help to mitigate this, the issue will still prevail in the long run with a buy-and-hold approach. The annual management fee erodes the initial trading spread advantage of bond ETFs over time. The second issue is that there is little room for creativity while creating a portfolio. Bond ETFs, for example, may not be the best choice for investors seeking a high level of income or no immediate income at all.
What’s the difference between a bond fund and a bond exchange-traded fund (ETF)?
Bond funds and bond ETFs (exchange-traded funds) are both mutual funds that invest in a portfolio of bonds or debt instruments. Bond funds and mutual funds are pools of money from investors that the fund management invests in a variety of securities. A bond ETF tracks a bond index with the purpose of mimicking the underlying index’s returns.
Bond funds and bond ETFs have a number of traits, including the ability to diversify their portfolios by holding a variety of bonds. Both mutual funds and exchange-traded funds offer lower minimum investment requirements than would be required to obtain the same amount of diversity by acquiring individual bonds in a portfolio.
Before comparing bond funds and bond ETFs, it’s important having a look at why people buy bonds in the first place. The majority of investors include bonds in their portfolios to produce income. A bond is a debt instrument that pays the bondholder an annual interest rate known as the coupon rate. Although buying and selling bonds to profit from price swings is a valid strategy, most investors acquire bonds to get interest payments.
Bonds are also purchased for risk reasons, as investors desire to park their money in a less volatile investment than equities. The degree to which the price of a securities swings over time is known as volatility.
Bond funds and bond ETFs both have the ability to pay dividends, which are cash payments made by firms in exchange for investing in their securities. Both types of funds provide a diverse range of investment options, including high-quality government bonds, low-quality corporate bonds, and everything in between.
In exchange for a nominal per-trade charge, funds and ETFs can also be acquired and sold through a brokerage account. Bond funds and bond ETFs, despite their similarities, have distinct characteristics.
Pros of bond ETFs
- A bond ETF distributes the interest it earns on the bonds it owns. As a result, a bond ETF can be an excellent method to build up an income stream without having to worry about individual bonds maturing or being redeemed.
- Dividends paid on a monthly basis. Some of the most popular bond ETFs pay monthly dividends, providing investors with consistent income over a short period of time. This means that investors can use the regular dividends from bond ETFs to create a monthly budget.
- Immediate diversification is required. A bond ETF can provide rapid diversification throughout your entire portfolio as well as inside the bond segment. As a result, if you add a bond ETF to your portfolio, your returns will be more resilient and consistent than if you simply had equities in your portfolio. Diversification reduces risk in most cases.
- Bond exposure that is tailored to your needs. You can have multiple types of bond ETFs in your bond portfolio, such as a short-term bond fund, an intermediate-term bond fund, and a long-term bond fund. When added to a stock-heavy portfolio, each will react differently to fluctuations in interest rates, resulting in a less volatile portfolio. This is advantageous to investors because they may pick and choose which market segments they want to acquire. Do you only want a small portion of intermediate-term investment-grade bonds or a large portion of high-yield bonds? Check and double-check.
- There’s no need to look at individual bonds. Rather than researching a range of individual bonds, investors can choose the types of bonds they want in their portfolio and then “plug and play” with the appropriate ETF. Bond ETFs are also a great option for financial advisers, particularly robo-advisors, who are looking to round out a client’s diverse portfolio with the correct mix of risk and return.
- It’s less expensive than buying bonds directly. Bond markets are generally less liquid than stock markets, with substantially greater bid-ask spreads that cost investors money. By purchasing a bond ETF, you are leveraging the fund company’s capacity to obtain better bond pricing, lowering your own expenses.
- You don’t require as much cash. If you want to buy a bond ETF, you’ll have to pay the price of a share (or even less if you choose a broker that permits fractional shares). And that’s a lot better than the customary $1,000 minimum for buying a single bond.
- Bond ETFs also make bond investment more accessible to individual investors, which is a fantastic feature. In comparison to the stock market, the bond market can be opaque and lack liquidity. Bond ETFs, on the other hand, are traded on the stock exchange like stocks and allow investors to quickly enter and exit positions. Although it may not appear so, liquidity may be the single most important benefit of a bond ETF for individual investors.
- Tax-efficiency. The ETF structure is tax-efficient, with minimal, if any, capital gains passed on to investors.
Cons of bond ETFs
- Expense ratios could be quite high. If there’s one flaw with bond ETFs, it’s their expense ratios — the fees that investors pay to the fund management to administer the fund. Because interest rates are so low, a bond fund’s expenses may eat up a significant percentage of the money provided by its holdings, turning a small yield into a negligible one.
- Returns are low. Another potential disadvantage of bond ETFs has less to do with the ETFs themselves and more to do with interest rates. Rates are expected to remain low for some time, particularly for shorter-term bonds, and the situation will be aggravated by bond expense ratios. If you buy a bond ETF, the bonds are normally chosen by passively mirroring an index, thus the yields will most likely represent the larger market. An actively managed mutual fund, on the other hand, may provide some extra juice, but you’ll almost certainly have to pay a higher cost ratio to get into it. However, in terms of increased returns, the extra cost may be justified.
- There are no promises about the principal. There are no assurances on your principal while investing in the stock market. If interest rates rise against you, the wrong bond fund might lose a lot of money. Long-term funds, for example, will be harmed more than short-term funds as interest rates rise. If you have to sell a bond ETF while it is down, no one will compensate you for the loss. As a result, for some savers, a CD may be a preferable option because the FDIC guarantees the principal up to a limit of $250,000 per person, per account type, at each bank.
Is bond investing a wise idea in 2021?
Because the Federal Reserve reduced interest rates in reaction to the 2020 economic crisis and the following recession, bond interest rates were extremely low in 2021. If investors expect interest rates will climb in the next several years, they may choose to invest in bonds with short maturities.
A two-year Treasury bill, for example, pays a set interest rate and returns the principle invested in two years. If interest rates rise in 2023, the investor could reinvest the principle in a higher-rate bond at that time. If the same investor bought a 10-year Treasury note in 2021 and interest rates rose in the following years, the investor would miss out on the higher interest rates since they would be trapped with the lower-rate Treasury note. Investors can always sell a Treasury bond before it matures; however, there may be a gain or loss, meaning you may not receive your entire initial investment back.
Also, think about your risk tolerance. Investors frequently purchase Treasury bonds, notes, and shorter-term Treasury bills for their safety. If you believe that the broader markets are too hazardous and that your goal is to safeguard your wealth, despite the current low interest rates, you can choose a Treasury security. Treasury yields have been declining for several months, as shown in the graph below.
Bond investments, despite their low returns, can provide stability in the face of a turbulent equity portfolio. Whether or not you should buy a Treasury security is primarily determined by your risk appetite, time horizon, and financial objectives. When deciding whether to buy a bond or other investments, please seek the advice of a financial counselor or financial planner.
Are exchange-traded funds (ETFs) safer than stocks?
Exchange-traded funds, like stocks, carry risk. While they are generally considered to be safer investments, some may provide higher-than-average returns, while others may not. It often depends on the fund’s sector or industry of focus, as well as the companies it holds.
Stocks can, and frequently do, exhibit greater volatility as a result of the economy, world events, and the corporation that issued the stock.
ETFs and stocks are similar in that they can be high-, moderate-, or low-risk investments depending on the assets held in the fund and their risk. Your personal risk tolerance might play a large role in determining which option is best for you. Both charge fees, are taxed, and generate revenue streams.
Every investment decision should be based on the individual’s risk tolerance, as well as their investment goals and methods. What is appropriate for one investor might not be appropriate for another. As you research your assets, keep these basic distinctions and similarities in mind.
Is it possible to lose all of my money in ETFs?
While there are many wonderful new ETFs on the market, anything promising a free lunch should be avoided. Examine the marketing materials carefully, make an effort to thoroughly comprehend the underlying index’s strategy, and be skeptical of any backtested returns.
The amount of money invested in an ETF should be inversely proportionate to the amount of press it receives, according to the rule of thumb. That new ETF for Social Media, 3-D Printing, and Machine Learning? It isn’t appropriate for the majority of your portfolio.
8) Risk of Overcrowding in the Market
The “hot new thing risk” is linked to the “packed trade risk.” Frequently, ETFs will uncover hidden gems in the financial markets, such as investments that provide significant value to investors. A good example is bank loans. Most investors had never heard of bank loans until a few years ago; today, bank-loan ETFs are worth more than $10 billion.
That’s fantastic… but keep in mind that as money pours in, an asset’s appeal may dwindle. Furthermore, some of these new asset types have liquidity restrictions. Valuations may be affected if money rushes out.
That’s not to say that bank loans, emerging market debt, low-volatility techniques, or anything else should be avoided. Just keep in mind while you’re buying: if this asset wasn’t fundamental to your portfolio a year ago, it should still be on the periphery today.
9) The Risk of Trading ETFs
You can’t always buy an ETF with no transaction expenses, unlike mutual funds. An ETF, like any other stock, has a spread that can range from a penny to hundreds of dollars. Spreads can also change over time, being narrow one day and broad the next. Worse, an ETF’s liquidity can be superficial: the ETF may trade one penny wide for the first 100 shares, but you may have to pay a quarter spread to sell 10,000 shares rapidly.
Trading fees can drastically deplete your profits. Before you buy an ETF, learn about its liquidity and always trade with limit orders.
10) The Risk of a Broken ETF
ETFs, for the most part, do exactly what they’re designed to do: they happily track their indexes and trade close to their net asset value. However, if something in the ETF fails, prices can spiral out of control.
It’s not always the ETF’s fault. The Egyptian Stock Exchange was shut down for several weeks during the Arab Spring. The only diversified, publicly traded option to guess on where the Egyptian market would open after things calmed down was through the Market Vectors Egypt ETF (EGPT | F-57). Western investors were very positive during the closure, bidding the ETF up considerably from where the market was prior to the revolution. When Egypt reopened, however, the market was essentially flat, and the ETF’s value plunged. Investors were burned, but it wasn’t the ETF’s responsibility.
We’ve seen this happen with ETNs and commodity ETFs when the product has stopped issuing new shares for various reasons. These funds can trade at huge premiums, and if you acquire one at a significant premium, you should expect to lose money when you sell it.
ETFs, on the whole, do what they say they’re going to do, and they do it well. However, to claim that there are no dangers is to deny reality. Make sure you finish your homework.
Is it possible to sell bond funds at any time?
Bonds are income-producing investments that can be bought and sold freely on the open market. This distinguishes them from other assets, such as bank certificates of deposit, which carry a penalty if sold prematurely. Although you can sell a bond whenever you find a suitable buyer, many bondholders choose to wait until the bond matures before selling it. Although there is no penalty for selling a bond before its maturity date, there may be charges associated with doing so.
Are bond index funds a safe investment?
Any investment entails some level of risk. The same is true for bond index funds. We’ll go through some of the disadvantages you should be aware of in the section below.
Volatility: Government assets, particularly those issued by the United States government, are held by the majority of broad-based bond index funds. As a result, interest rate swings have a significant impact on them.
Bonds are widely seen as safe investments by most investors, despite the fact that there is always some risk involved. Safer investments, on the other hand, tend to yield lower long-term returns.
Time horizon: When investing in individual bonds, the longer you hold them and the closer they approach to maturity, the lower your risk becomes. This isn’t always the case with bond funds. Because they are made up of a variety of bonds, the issues are constantly maturing and being purchased and sold.