What Is a Bond ETF?

Bond ETFs are a type of exchange-traded fund (ETF) that exclusively invests in bonds. These are similar to bond mutual funds because they hold a portfolio of bonds with different particular strategies, from U.S. Treasuries to high yields, and holding periods, between long-term and short-term.

Bond ETFs are passively managed and trade, much like stock ETFs on major stock exchanges. This helps promote market stability by adding liquidity and transparency during times of stress. 

Key Takeaways

  • Bond ETFs are exchange traded funds that invest in various fixed-income securities such as corporate bonds or Treasuries.
  • Bond ETFs allow ordinary investors to gain passive exposure to benchmark bond indices in an inexpensive way.
  • Investors should understand the risks to bond ETFs including the effect of interest rate changes.
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An Introduction To Exchange-Traded Funds (ETFs)

Understanding Bond ETFs

Bond ETFs trade throughout the day on a centralized exchange, unlike individual bonds, which are sold over the counter by bond brokers. The structure of traditional bonds makes it difficult for investors to find a bond with an attractive price. Bond ETFs avoid this issue by trading on a major index like the New York Stock Exchange.

As such, they can provide investors with the opportunity to gain exposure to the bond market with the ease and transparency of stock trading. It also means bond ETFs are more liquid than individual bonds and mutual funds, which trade at one price per day after the market closes. During times of distress, investors can trade a bond portfolio, even if the underlying bond market is not functioning well.

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.

The bond ETF market is still in its relative infancy. As of June 2015, bond ETFs held about $318 million in assets under management or less than 1% of the total market. So if bond ETFs were to fall, the entire bond market would be unaffected.

How Bond ETFs Work

Bond ETFs offer many of the same features of an individual bond, including a regular coupon payment. One of the most significant benefits of owning bonds is the chance to receive fixed payments on a regular schedule. These payments traditionally happen every six months. Bond ETFs, in contrast, hold assets with different maturity dates, so at any given time, some bonds in the portfolio may be due for a coupon payment. For this reason, bond ETFs pay interest each month with the value of the coupon varying from month to month.

Assets in the fund are continually changing and do not mature. Instead, bonds are bought and sold as they expire or exit the target age range of the fund. 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. Given the liquidity of government bonds, tracking errors will be less of a problem with ETFs that represent government bond indices.

Disadvantages of Bond ETFs

Bond ETFs are a great option to gain exposure to the bond market, but there are some glaring limitations. For one thing, an investor's initial investment is at greater risk in an ETF than an individual bond. Since a bond ETF never matures, there isn't a guarantee the principal will be repaid in full. Furthermore, when interest rates rise, it tends to harm the price of the ETF, like an individual bond. As the ETF does not mature, however, it's difficult to mitigate interest rate risk.

Bond ETFs vs. Bond Mutual Funds

The decision over whether to purchase a bond fund or a bond ETF usually depends on the investment objective of the investor. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs are a good choice. For long-term, buy-and-hold investors, bond mutual funds, and bond ETFs can meet your needs, but it's best to do your research as to the holdings in each fund.

If transparency is important, bond ETFs allow you to see the holdings within the fund at any given moment. However, if you're concerned about not being able to sell your ETF investment due to the lack of buyers in the market, a bond fund might be a better choice since you'll be able to sell your holdings back to the fund issuer.

As with most investment decisions, it's important to do your research, speak with your broker or financial advisor.

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.

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.