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DEFINITION of 'Bond ETF'

Bond ETFs are a type of exchange-traded fund (ETF) that exclusively invest in bonds. They are like bond mutual funds because they hold a portfolio of bonds with different 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 a major exchange. This helps promote market stability by adding liquidity and transparency during times of stress. 

BREAKING DOWN 'Bond ETF'

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.

The bond ETF market is still in its 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. 

Bond ETFs offer many of the same features of an individual bond including a regular coupon payment. One of the biggest 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.

Disadvantages of Bond ETF

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 have an adverse effect on the price of the ETF, like an individual bond. As the ETF does not mature, however, it's difficult to mitigate interest rate risk.

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