While some electronic bond trading is available to retail investors, the entire bond market remains an over-the-counter market. Unlike stock trading - for which automation has leveled the playing field for retail and institutional investors - the bond market lacks liquidity and price transparency except for the most liquid of bonds. For the self-directed bond investor, for whom it may make little sense to invest in expensive actively managed bond funds, exchange-traded funds (ETFs) which track bond indices may offer a good alternative.

Tutorial: ETF Alternative Investments

Overview of Bond ETFs
While similar to other ETFs, bond ETFs are unique in the world of fixed income because, as they are traded on stock exchanges, the current and historical prices of bond ETFs are available to all investors. Historically, this kind of price transparency for bonds has been available only to institutional investors.

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.

The suppliers of bond ETFs get around the liquidity problem by using representative sampling, which simply means tracking only a sufficient number of bonds to represent an index. The bonds used in the representative sample tend to be the largest and most liquid in the index. For example, the Lehman Aggregate Bond Index contains more than 6,000 bonds, but the Barclays iShare Lehman Aggregate Bond Fund (AGG) contains only a little over 100 of those bonds. Given the liquidity of government bonds, tracking errors will be less of a problem with ETFs that represent government bond indices.

Bond ETFs pay out interest through a monthly dividend, while any capital gains are paid out through an annual dividend. For tax purposes these dividends are treated as either income or capital gains. However, the tax efficiency of bond ETFs is not a big factor, because capital gains do not play as big of a part in bond returns as they do in stock returns.

Finally, bond ETFs are available on a global basis. Barclays Global Investors, for example, has created ETFs that are available in the U.S., Europe and Canada.

Bond ETFs Vs. Bond Ladders
The liquidity and transparency of an ETF offers advantages over a passively held bond ladder. Bond ETFs offer instant diversification and a constant duration, which means an investor needs to make only one trade to get a fixed-income portfolio up and running. A bond ladder, which requires buying individual bonds, does not offer this luxury. (For more information see Boost Bond Returns With Laddering.)

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 product for him or her.

Bond ETFs Versus Index Bond Funds

Bond ETFs and index bond funds cover similar indices, use similar optimization strategies and have similar performance. Bond ETFs, however, are the better alternative for those looking for more flexible trading and better transparency. The make-up of the underlying portfolio for a bond ETF is available daily online, but this type of information for index bond funds is available only on a semi-annual basis. Furthermore, on top of being able to trade bond ETFs throughout the day, active traders can enjoy the ability to use margin, sell short and trade options on these securities. (To learn about index funds read The Lowdown On Index Funds.)

The main disadvantage of bond ETFs is the trading commissions they generate. Therefore, they make more sense for larger and less frequent trades. However, ETFs don't pose this disadvantage for investors who purchase their index bond funds through a third party (such as an online broker), which also charges a fee for the fund trade.

The Bottom Line
The bond ETF is an exciting new addition to the bond market, offering an excellent alternative to self-directed investors who, looking for ease of trading and increased price transparency, want to practice indexing or active bond trading. However, bond ETFs are suitable for particular strategies. If, for instance, you are looking to create a specific income stream, bond ETFs may not be for you. Be sure to compare your alternatives before investing.

Related Articles
  1. Retirement

    How Are 401(k) Withdrawals Taxed for Nonresidents?

    As a U.S. nonresident, deciding what to do with your 401(k) after you return home comes down to which tax penalties, if any, you're willing to incur.
  2. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  3. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  4. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  5. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  6. Investing Basics

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  7. Stock Analysis

    3 Solar Stocks to Add to Your Portfolio

    Understand the growth and challenges of the renewable energy market and its success in 2015. Learn about the top three energy stocks to add to a portfolio.
  8. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  9. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  10. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  1. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  2. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  3. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  4. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  5. Can my 401(k) be seized or garnished?

    As long as your retirement funds are held in your 401(k) and you do not take them as distributions, your 401(k) cannot be ... Read Full Answer >>
  6. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!