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.
What’s the difference between an ETF and a bond?
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.
How are BOND ETFs profitable?
The closer a bond’s maturity date approaches, the more vulnerable it is to rate increases. When all other factors are equal, a 10-year bond has a higher interest rate risk than a five-year bond since your money is exposed to rising interest rates for a longer length of time.
A time-weighted measure of interest-rate risk is called duration. Duration predicts how a bond’s price will fluctuate in reaction to interest rate fluctuations. More interest-rate risk is associated with longer periods. A duration of 3.5, for example, suggests that if interest rates rise by 1%, the value of a bond will fall by 3.5 percent.
- The duration is a guess, not a guarantee. Bond prices rise when interest rates fall, but this isn’t a one-to-one relationship. Price increases from dropping rates are undervalued by duration, whereas price declines from rising yields are overestimated.
- Duration is based on a simplified interest-rate scenario. When interest rates move by 1% across all maturities, duration is calculated; in other words, when rates change, the entire yield curve shifts by 1% up or down. It’s rare that reality is so exact.
Bond ETFs typically pay out income on a monthly basis. One of the most appealing features of bonds is that they pay interest to investors on a regular basis, usually 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 make monthly rather than semiannual coupon payments. This payment’s amount varies from month to month.
Traditional bond indexes are excellent benchmarks but poor portfolio builders. The majority of equities ETFs hold all of the securities in their index. However, with bonds, this is usually not achievable. Hundreds, if not thousands, of individual securities are frequently included in bond indexes. It’s not only tough, but also expensive to buy all those bonds for an ETF’s portfolio. Even if the purchase of thousands of bonds in illiquid markets has a minor impact on the index, the cost of doing so can significantly erode returns.
Managers of bond ETFs frequently tweak their indexes. To keep expenses down, fund managers must often pick and select which bonds from the bond index to include in the ETF. They’ll choose bonds that, based on credit quality, exposure, correlations, duration, and risk, provide the best representative sample of the index. The term “optimization” or “sampling” refers to this process.
Optimizing saves money, but it comes with its own set of hazards. Over time, an ETF’s returns may diverge from those of its index, depending on how aggressively its portfolio was optimized. The majority of ETFs closely track their underlying indexes; nevertheless, a few have fallen short of their benchmark by a few percentage points or more per year. (For further information, see “How To Run An Index Fund: Full Replication vs. Optimization.”)
Individual bond values are difficult to estimate. There is no one agreed-upon price for the value of every bond without an official exchange. Many bonds, in reality, do not trade on a daily basis; particular forms of municipal bonds, for example, can go weeks or months without trading.
To calculate NAV, fund managers need precise bond prices. Bond pricing services, which estimate the value of individual bonds based on recorded trades, trading desk surveys, matrix models, and other factors, are used by both mutual fund and ETF managers. Of course, nothing is certain. But it’s a reasonable guess.
The share price of an ETF isn’t the same as its NAV. The share price of a bond mutual fund is always the same as its net asset value, or the value of the underlying assets in the portfolio. The share price of a bond ETF, on the other hand, can fluctuate depending on market supply and demand. When share prices rise above NAV, premiums form, and when prices fall below NAV, discounts form. However, there is a natural mechanism in place to maintain the share price and NAV of a bond ETF in sync: arbitrage.
Arbitrage is used by APs to keep ETF share prices and NAV in sync. Authorized participants (APs), a unique class of institutional investors, have the right to create or destroy shares of the ETF at any moment. If an ETF’s share price falls below its NAV, APs can profit from the difference by purchasing ETF shares on the open market and trading them into the issuer in exchange for a “in kind” exchange of the underlying bonds. The AP only needs to liquidate the bonds in order to profit. Similarly, if the share price of an ETF increases above NAV, APs can buy individual bonds and exchange them for ETF shares. Arbitrage produces natural purchasing or selling pressure, which helps keep the share price and NAV of an ETF from drifting too far apart.
An ETF’s price may be significantly below its declared NAV in stressed or illiquid markets, or for an extended length of time. When this happens, it simply signifies that the ETF industry believes the bond pricing service is incorrect, and that the prices for the fund’s underlying bonds are being overestimated. In other words, the APs don’t think they’ll be able to sell the underlying bonds for their stated valuations. This means that the ETF price falls below its NAV, which is good news for ETF investors. (Any premiums that may accrue follow the same procedure.)
Large premiums and discounts in a bond ETF don’t always indicate mispricing. Highly liquid bond ETFs can perform price discovery for the bonds they hold, and an ETF’s market price can actually be a better approximation of the aggregate value of the underlying bonds than its own NAV.
Is it wise to invest in bond ETFs?
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.
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.
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.
Which mutual fund is the safest?
Bond mutual funds are a good substitute for buying bonds directly. Bond mutual funds, on the whole, have one of the lowest risk profiles among all mutual funds.
You buy the quantity of shares you want, just like any other mutual fund, and a skilled money manager scours the fund’s portfolio for the best bonds. Government bond funds, municipal bond funds, and short-term corporate bond funds are the three types of bond funds that are considered the safest.
What are the most secure bonds to buy?
- Bonds are a fantastic alternative if you wish to protect your principal with a safe investment.
- Savings bonds, Treasury bills, banking instruments, and U.S. Treasury notes are among the safest bonds.
- Stable value funds, money market funds, short-term bond funds, and other high-rated bonds are examples of safe bonds.
- Diversifying your portfolio across two or more market segments is desirable since it prevents you from putting all of your eggs in one basket.
Bond ETFs are they considered fixed-income?
Fixed-income ETFs are bond funds whose shares are traded throughout the day on a stock exchange. There are fixed-income ETFs that track the Bloomberg Barclays Aggregate Bond Index, as well as funds that track corporate, government, municipal, international, and global debt.
Are bond ETFs considered fixed-income investments?
Bonds are loans to businesses, governments, and other entities. Investors make a loan to the company and later receive interest on their investment. Bond exchange-traded funds (ETFs) are fixed-income funds that allow investors to profit from interest payments, unlike stock ETFs.
Many bond ETFs track benchmarks like the Bloomberg U.S. Aggregate Bond Index, while others focus on municipal, corporate, government, and international debt. Bond ETFs with particular maturity dates are also available for purchase.
The prognosis for the bond market is altering as a result of the Federal Reserve’s (Fed) plans. The Fed is taking attempts to keep inflation in check, while investors are concerned about COVID-19’s return owing to the Omicron variation. As the economy approaches full employment in March 2022, the central bank aims to halt its pandemic-era bond-buying program. While decreasing asset purchases allows the Fed to raise interest rates more quickly, it also comes with hazards. Investors in the bond market are concerned that the program would result in short-term interest rates falling below the Fed’s forecasted peak.