Building a diversified bond portfolio is a time-consuming task that requires an amount of money that is beyond the means of many investors. Fortunately, mutual funds and exchange-traded funds (ETFs) offer convenient alternatives. Understanding the pros and cons of each will help you choose the one that is right for you.
Why Buy Bonds?
Before comparing bond funds and bond ETFs, it is worth taking a few moments to review the reasons why investors buy bonds. Most investors put bonds in a portfolio to generate income. While buying and selling bonds in an effort to generate a profit is a viable strategy, this type of activity is more common among professional investors than among individuals.
Investors also buy bonds for risk-related reasons, as they seek to store their money in an investment that is less volatile than stocks. Before investing in bonds, you should have a clearly defined reason for doing so, as it will help you choose the right investment vehicle.
To learn more about bonds, read the Bond Basics Tutorial.
Bond Funds and Bond ETFs Characteristics
Bond funds and bond ETFs share several characteristics. Both offer diversification via portfolios that hold numerous bonds. Both do so with a significantly smaller minimum required investment than would be necessary to achieve the same level of diversification by purchasing individual bonds and using them to construct a portfolio. Both pay dividends and capital gains on a regularly scheduled basis, which serve as an income stream for investors. Both offer a wide variety of investment choices ranging from high-quality government bonds to low-quality corporate bonds and everything in between. And both can be purchased and sold through a brokerage account in exchange for a small per-trade fee. Despite these similarities, bond funds and bond ETFs also have some unique, unshared characteristics.
Bond Funds Characteristics
Mutual fund have been investing in bonds for a long time. Some of the oldest balanced funds (which include allocations to both stock and bonds) date back to the late 1920s. Accordingly, there are a large number of bond funds in existence offering a significant variety of investment options. These include both index funds, which seek to replicate various benchmarks and make no effort to outperform those benchmarks, and actively managed funds, which seek to beat their benchmarks. Actively managed funds also employ credit analysts to conduct research into the credit quality of the bonds the fund purchases in an effort to minimize the risk of purchasing bonds that are likely to default.
Bond funds are available in two different structures: open-ended funds and closed-end funds. Open-ended funds can be bought directly from fund providers, which means they do not need to be purchased through a brokerage account. If purchased directly, the brokerage commission fee can be avoided. Similarly, bond funds can be sold back to the fund company that issued the shares, making them highly liquid.
In addition, open-ended funds are priced and traded once a day, after the market closes and each fund’s net asset value (NAV) is determined. The trading price is a direct reflection of the NAV, which is based on the value of the bonds in the portfolio. Open-ended funds do not trade at a premium or a discount, making it easy and predictable to determine precisely how much a fund’s shares will generate if sold. Notably, some bond funds charge an extra fee if they are sold prior to a certain minimum required holding period (often 90 days), as the fund company wishes to minimize the expenses associated with frequent trading.
Interestingly, bond funds do not reveal their underlying holdings on a daily basis. They generally release holdings on a semi-annual basis, with some funds reporting monthly. This lack of transparency makes it difficult for investors to determine the precise composition of their portfolios at any given time.
Bond ETFs Characteristics
Bond ETFs are a far newer entrant to the market, with iShares launching the first one in 2002. Most of these offerings seek to replicate various bond indices, although a growing number of actively managed products are coming to market. The launch of an ETF that seeks to replicate PIMCO’s famous Total Return Bond, the PIMCO Active Bond Fund (BOND), in 2012 was a noteworthy development. ETFs often have lower fees than their mutual fund counterparts, potentially making them the more attractive choice to some investors if the identical strategy is available as either an ETF or an open-ended mutual fund.
Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company. Likewise, when an investor wishes to sell, ETFs must be traded on the open market—meaning that a buyer must be found because the fund company will not purchase the shares as they would for open-ended mutual funds.
Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of trading. Extremes in price fluctuation have been seen during market anomalies, such as the so-called Flash Crash of 2010. Shares can also trade at a premium or a discount to the underlying net asset value of the holdings. While significant deviations in value are relatively infrequent, they are not unheard of. Deviations may be of particular concern during crisis periods, for example, if a large number of investors are seeking to sell bonds. In such events, an ETF price may reflect a discount to NAV because the ETF provider is not certain that existing holdings could be sold at their current stated net asset value.
Bond ETFs do not have a minimum required holding period, meaning that there is no penalty imposed for selling rapidly after making a purchase. They can also be bought on margin and sold short, offering significantly greater flexibility in terms of trading than open-ended mutual funds. Also, bond ETFs reveal their underlying holdings on a daily basis, giving investors complete transparency. For more information, see A Guide for Buying ETFs on Margin.
Bond Fund or Bond ETF?
The decision over whether to purchase a bond fund or a bond ETF is less about which investment vehicle is better or worse and more about what your needs and objectives are as an investor. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs enable you do to so. If you are a long-term, buy-and-hold investor, bond mutual funds meet your needs.
If knowing exactly what you hold at any given moment is important to you, bond ETFs provide the required transparency. If you take comfort in the ability to sell your holdings back to the issuer on any given day, bond funds offer that security.
The Bottom Line
Ultimately, both vehicles provide access to the bond markets. Both offer diversified portfolios. Both offer a convenient way to build a portfolio. The choice of one over the other is likely to be based more on personal preference or specific investment need rather than superiority/inferiority in terms of bond market exposure or portfolio diversification. As with most investment decisions, the first move you make should involve learning as much as you can about the investment you are considering. When you understand what you are about to buy and why you are buying, you have a better chance of making a wise decision.