When it comes to investing, there are many different options to pursue, from stocks and bonds to commodities and mutual funds to real estate investment trusts and more. The options are endless – and often confusing.
But any investment professional worth their fees will let you know the importance of diversifying your portfolio with a mix of investments. Otherwise, you risk putting all your proverbial eggs in one high-risk investment basket.
You can achieve diversification in an instant with a bond exchange-traded fund (ETF). Bond ETFs are new-ish investment products, but they’ve become a popular way to combine the lower risk of bonds with the easy cash convertibility of stocks.
We’ve put together a primer on bond ETFs to help you understand how they work and the pros and cons of investing in them.
What Are Bond ETFs?
Before we talk about bond ETFs, let’s discuss their parts.
A bond is a loan you (the investor) make to a government or a company that lasts for a predetermined period (aka the bond’s term). The bond matures at the end of its term, and you cash it out for its original value plus a small profit.
You may receive a bond coupon that guarantees regular dividends on the bond. You usually receive a payment every 6 months. But you can’t sell the bond until it matures.
Bonds are a relatively stable investment compared to stocks, so investors with a lower tolerance for risk typically prefer bonds.
An ETF is an investment fund that bundles different asset classes, including stocks, bonds and commodities. ETFs receive a ticker symbol and are traded like stocks on a stock exchange.
Unlike mutual funds, ETFs are not actively managed. They usually track a popular trading index like Nasdaq or the S&P 500. ETFs are less expensive, and they require less maintenance.
ETFs have been around since the late 90s and have steadily climbed in popularity. Between 2000 and 2021, ETFs have grown from 80 funds to over 2,600. Bond ETFs have over $1.2 trillion in net assets and represent 17% of the total ETF market.
When you put a bond and an ETF together, you get a bond ETF.
A bond ETF is made up of an assortment of bonds, including government and corporate bonds. The bonds are bundled into a fund and openly traded throughout the day on an exchange like the New York Stock Exchange.
Because a bond ETF is made up of different types of bonds with different maturity terms, it pays out more frequently than an individual bond would, usually every month.
How Do Bond ETFs Work?
Because a bond ETF is openly traded on an exchange, you can buy and sell a bond ETF on the same day, just like a stock. You may be partially invested in bond ETFs if you have a managed portfolio through a retirement or pension fund. If not, you can buy shares in bond ETFs through brokerage firms, including online trading platforms.
Types of Bond ETFs
There are many different types of bond ETFs out there, but most bond ETFs fall into one of four categories: sovereign, municipal, corporate and broad market.
Sovereign bond ETF
A sovereign bond ETF includes bonds from governments and government-backed market sectors.
- U.S. Treasury bonds: T-bonds are the gold standard of investing. When you buy a Treasury bond (sometimes referred to as a T-bill), you buy a share of the U.S. financial system.
- Treasury inflation-protected securities: This special class of Treasury security is indexed to inflation (think: automatically adjusts to keep pace with inflation). Investors don’t lose money when inflation is high and the price of everything from cars to cereal skyrockets.
- International bonds: These are bundles of non-U.S. government or company bonds. Investors may purchase international bonds to hedge against losses on the U.S. dollar and financial markets.
- Emerging market bonds: The bonds are issued by countries that want to achieve short-term economic growth goals. The bonds can offer a higher rate of return – but they are riskier.
- Mortgage bonds: Mortgage bonds are backed by property. The interest investors earn comes from the interest homeowners pay on their mortgages.
Municipal bond ETF
States, cities or counties offer municipal bonds to raise funds for local operating expenses and to pay for infrastructure projects, like schools and roads.
Corporate bond ETF
Corporations sell bonds to raise capital. There are different corporate bonds, including convertible bonds, which can convert to corporate stock or high-risk junk bonds.
Broad market bond ETF
A broad market bond ETF pools different bond types. The ETF may include everything from the highest-rated investment grade bonds to junk bonds.
Bond ETFs vs. Bond Mutual Funds
Are you wondering what the difference is between bond ETFs and bond mutual funds? A bond mutual fund also allows investors to buy a collection of diversified bonds – but there are key differences between the two.
- Share price: The price of bond ETFs changes all day. Bond mutual funds trade once a day and their prices are set after a stock exchange closes.
- Management fees: Bond ETFs charge management fees, but they are usually lower than the fees charged for actively managed bond mutual funds.
- Tax liabilities: While bond ETFs have minimal capital gains, bond mutual funds pay capital gains distributions (think: investment profits that can be taxed) at the end of the year, which can cost you more in taxes.
- Entry price: Bond ETFs have a lower point of entry than bond mutual funds. You can buy into an ETF with one share or a fraction of a share. Many bond funds require a minimum investment of a few thousand dollars.
What Are the Pros and Cons of Bond ETFs?
An individual bond can cost $1,000 minimum. You can buy bond ETF shares (or fractions of shares) for under $100 per share.
Instead of researching individual bonds and tracking their progress, the bonds in a bond ETF are already managed. All you have to do is invest and collect your monthly payments.
You can check the price of your bond ETF any minute of the day because bond ETFs are traded throughout the day like a stock.
Bond ETFs are tax-efficient and have minimal capital gains, which could save you money at tax time.
While individual bonds typically pay out dividends every 6 months, bond ETFs provide monthly dividends.
Because bond ETFs are a collection of different bonds, they offer more diversification than a traditional bond. Spreading your investments across bond types can help protect your money from market volatility.
While bond ETFs offer the benefit of being managed, you pay a premium on management fees. The fees can cut into your profits.
Because bond ETFs are tied to the broader market, their value can change with interest rates or market downturns. When that happens, you risk losing your money.
Most bonds pay a fixed interest rate, making them a more attractive investment when interest rates are low. When interest rates go up, bonds become less valuable to investors and their market price falls.
When inflation soars, the relatively steady (but modest) dividends from bond ETFs can lose value in comparison to investments that offer a higher rate of return.
Are Bond ETFs a Good Investment?
Whether bond ETFs are right for you depends on your investment objectives.
For instance, the popularity of bond ETFs is growing among investors approaching retirement. Soon-to-be retirees usually want to keep their investment risk low – especially if they expect to live on a fixed income. Bond ETFs offer a good mix of stability with a decent rate of return and allow investors to convert their assets to cash if they need money in a hurry.
But if you’re a new investor with time to grow your portfolio, think long-term and embrace an investment strategy that offers higher returns in the long run.
If you’re interested in bond ETFs, you should research fund management companies. Most issuers will provide you with a prospectus, which predicts future results based on past performance.
Don’t make investment decisions lightly. Make sure you’re working with an experienced investment manager who can help you find an investment strategy curated for your needs and goals.
The Short Version
- A bond ETF is made up of an assortment of bonds, including government and corporate bonds
- If you’re a new investor with time to grow your portfolio, think long-term and embrace an investment strategy that offers higher returns in the long run
- Because a bond ETF is openly traded on an exchange, you can buy and sell a bond ETF on the same day, just like a stock