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.

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