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), an 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.
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.
What causes bond ETF prices to fluctuate?
ETFs can be purchased through your stockbroker, financial advisor, or internet trading platform in the same way that you would buy stocks. Of course, before you purchase or sell ETFs, you should be aware of the fundamental variables that influence their prices.
The value of an ETF tends to rise or fall throughout the day, making its price dynamic. This is in response to the underlying index that the ETF tries to track fluctuating.
Unit trust structure
ETFs use a unit trust structure, in which the assets of the unit trust are held by a trustee. Unit trusts are the most common investment structure in Australia, and they make up the great majority of traditional managed funds.
Given that the ETF’s assets are held ‘in trust’ by the ETF manager for the benefit of the ETF unitholders, the fact that the ETF is constituted as a trust provides a source of investor protection. This structure ensures that the ETF’s underlying assets are kept distinct from the fund manager’s holdings, providing an extra degree of protection in the event of the manager’s death.
How ETF units get created
ETFs are open-ended, meaning that the number of units available for purchase is not fixed, and the supply of units can fluctuate in response to investor demand.
The process of creating ETF units can be done in a number of ways “A mechanism in which the actual shares that underpin the index being tracked by the ETF are transferred to the ETF issuer in consideration for the formation of ETF units is known as a “in specie” contribution. The process of exchanging securities for ETF units is a “primary” market activity that takes place between the ETF provider, who creates the units, and the “Authorised Participants,” who are wholesale investment houses that receive them. ETF units can also be generated using a method other than ‘in specie’ creation “When cash (rather than assets) is traded for ETF units, this is referred to as “cash creations.”
Authorised Participants make ETF units available on the secondary market, i.e. the stock exchange, after they are formed in the primary market. This is the’secondary market,’ where you, as an investor, will buy and sell ETFs.
When the supply of ETF units exceeds demand, the ability to produce ETF units in the primary market in return for shares is matched by the ability to redeem the units in exchange for shares. One of the main reasons for the liquidity of ETFs is the ability of Authorised Participants to establish and redeem on demand in a specific ETF, as well as their open-ended nature.
Can a bond ETF fall in value?
This year, more than ever, investor loyalty to bond holdings will be put to the test.
Many sorts of assets have performed well in the last year or so, but bonds have not. The FTSE Canada Universe Bond Index fell 2.7% in the year to July 31, whereas the S&P/TSX composite index increased by 29%.
A Globe reader is struggling to reconcile bond performance with the justification for include bonds in a portfolio. “Why are most of my bond exchange-traded funds losing money if bonds are supposed to be such secure investments?” he wondered.
This individual has a number of bond ETFs that include both government and corporate bonds. “The majority have lost value, but they do pay interest, which compensates for the losses. Still, I’m not sure why they’re seen as safe. Because I’m 64, I’m advised to invest in bonds. “I’m not sure what you’re talking about.”
When interest rates rise, as they have this year, bond prices can decline. In the next months, we may see more of this. Bonds provide security by (a) paying semi-annual interest and (b) maturing and repaying investors’ money. Bond issuers do default on their obligations from time to time, although this is highly uncommon for financially sound firms and nearly unheard of for governments.
Bond ETFs are a great tool to diversify a portfolio’s bond exposure. Fees are modest, you gain quick diversification, and the yields are comparable to those of individual bonds. Bond ETFs, on the other hand, differ from individual bonds in that they never mature and return investors’ money.
That’s why they’re best for long-term investors who are willing to hold them through increasing interest rate cycles like we’re witnessing now and lowering rates in the future. When the ups and downs of the following decade are factored in, the combination of bond interest and price increases should generate a rate of return that lags stocks but tops cash.
Consider guaranteed investment certificates from alternative banks and credit unions for added security. They provide deposit insurance, competitive yields, and they do not fluctuate in price while you have them. However, it isn’t liquid.
Why do bonds lose value?
In essence, a bond’s price fluctuates based on the value of the income given by its coupon payments in comparison to broader interest rates. If current interest rates rise faster than the bond’s coupon rate, the bond loses its appeal.
Is it worthwhile to invest in bonds?
- Bonds are a generally safe investment, which is one of its advantages. Bond prices do not move nearly as much as stock prices.
- Another advantage of bonds is that they provide a consistent income stream by paying you a defined sum of interest twice a year.
- You may assist enhance a local school system, establish a hospital, or develop a public garden by purchasing a municipal bond.
- Diversification — One of the most important advantages of bond investment is the diversification it provides to your portfolio. Stocks have outperformed bonds throughout time, but having a mix of both lowers your financial risk.
Is there a difference between a bond and a bond 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.
When interest rates are low, should I buy bonds?
- Bonds are debt instruments issued by corporations, governments, municipalities, and other entities; they have a lower risk and return profile than stocks.
- Bonds may become less appealing to investors in low-interest rate settings than other asset classes.
- Bonds, particularly government-backed bonds, have lower yields than equities, but they are more steady and reliable over time, which makes them desirable to certain investors.
What happens if the price of bonds drops?
Most bonds pay a set interest rate that rises in value when interest rates fall, increasing demand and raising the bond’s price. If interest rates rise, investors will no longer favor the lower fixed interest rate offered by a bond, causing its price to fall.
Bond ETFs retain bonds until they mature.
Bond ETFs provide many of the same characteristics as actual bonds, such as a consistent coupon payment. One of the most important advantages of bond ownership is the ability to receive fixed payments on a regular basis. Traditionally, these payments are made every six months. Bond ETFs, on the other hand, own assets with varying maturities. As a result, some bonds in the portfolio may be due for a coupon payment at any given time. As a result, bond ETFs pay interest every month, with the coupon value fluctuating from month to month.
The fund’s assets are constantly changing and do not mature. Instead, bonds are purchased and sold as they approach or leave the fund’s designated age range. Despite the absence of liquidity in the bond market, the difficulty for the architect of a bond ETF is to guarantee that it closely matches its appropriate index in a cost-effective manner. Because most bonds are held until they mature, there is usually no active secondary market for them. This makes ensuring that a bond ETF has enough liquid bonds to mirror an index difficult. Corporate bonds face a greater challenge than government obligations.
Bond ETF providers get around the liquidity issue by utilizing representative sampling, which basically means tracking a small enough number of bonds to form an index. The representative sample bonds are often the largest and most liquid in the index. Tracking mistakes will be less of a concern with ETFs that represent government bond indices due to the liquidity of government bonds.
Bond ETFs are a terrific way to get exposure to the bond market, but they have a few drawbacks. For one reason, in an ETF, an investor’s initial investment is at greater risk than in a single bond. Because a bond ETF never matures, there is no certainty that the principal will be fully repaid. Furthermore, when interest rates rise, the ETF’s price, like the price of an individual bond, tends to fall. However, because the ETF does not mature, it is difficult to manage interest rate risk.