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Bond ETFs, also known as fixed-income ETFs, are exchange-traded funds that invest in bonds. These funds give investors exposure to the performance of fixed income indexes, along with regular dividends. A very wide variety of bond ETFs are available to investors.
What is a bond?
To understand bond ETFs, it’s important to first understand exactly what a bond is. Bonds, or fixed-income securities, are tradable loans. Governments, municipalities, and companies all sell bonds to source funds – but unlike a simple loan agreement, a bond can be traded in a secondary market, and the value can fluctuate.
Let’s say a company needs to borrow $1 million for 10 years and are prepared to pay annual interest of 5%. They will issue (sell) a bond with a face value of $1 million, a maturity date 10 years into the future, and a 5% coupon – to an investor who pays them the $1 million.
If the investor holds the bond for 10 years, they will receive $50,000 each year from the issuer, and they will receive $1 million on the maturity date. But they can also sell the bond to another investor. As long as the issuer doesn’t default on their obligation, the holder of the bond will continue to receive the $50,000 coupon and the principle of $1 million at maturity.
While the coupon and principal value don’t change, the bond may be bought and sold at different prices. If interest rates fall to 4%, a bond paying 5% becomes more valuable. But, if interest rates rise to 6%, a bond paying 5% loses value. The prices at which bonds trade in the secondary market fluctuate as interest rates fluctuate, and as the credit rating of the issuer changes.
Types of bonds
The following are the most common types of bonds:
Bond issues are the primary means of funding for governments. Bonds issued by the governments of developed nations typically have the highest credit ratings and are viewed as close to ‘risk-free’. The creditworthiness of bonds issued by governments in developing nations vary according to the strength of the economy, political stability, and the currency of the bond.
Cities and municipalities also issue bonds to fund development. These bonds are backed by rates, local taxes, and revenues from facilities like airports and toll roads. Municipal bonds sometimes offer additional tax benefits to investors.
Companies can sell shares to fund growth, or they can issue bonds. Corporate bonds pay fixed returns, unlike shares that give holders a stake in the company’s profits. However, if a company is liquidated, the bondholders have the first claim on the company’s assets. Convertible bonds are corporate bonds that can be converted into shares.
A mortgage bond bundles the mortgages on hundreds of homes into one bond. The bonds are backed by the properties, and coupons are paid out from monthly mortgage payments.
High yield and junk bonds
The terms junk bond and high yield bond are used interchangeably to refer to bonds that are rated below investment grade. Junk bonds offer higher yields to compensate holders for the additional risk. They can be issued by governments, municipalities, or corporates.
Bond indexes are constructed by defining bonds according to several characteristics, including the type of issuer and the credit rating. The currency, time to maturity, and duration (sensitivity to changes in interest rates) are also used to index bonds. Bond indexes can therefore change significantly when interest rates change.
Distinctions Between Direct bond investments & bond funds
While bond prices fluctuate in the secondary market, they always pay out the full face value, or principal, at maturity – unless they default. So, if you buy a bond and hold it till maturity, you will receive the full principal (face value), regardless of how much the price of the bond fluctuates along the way. But, if you sell it before maturity, you may realize a capital gain or loss.
A bond ETF tracks a fixed income index, and the index determines what types of bonds should be held at a given time. To keep the fund in line with the index, it is periodically rebalanced. This will result in realized gains or losses for investors. Gains result in the NAV of the fund rising, and in an annual capital gains dividend. Losses result in the NAV of the fund falling.
Bond ladders vs bond ETFs
When investors buy bonds directly, they will often construct a bond ladder. This entails buying bonds with different maturities, and then reinvesting the proceeds into a new bond when each bond matures. This is a good way to establish a series of predictable cashflows. It also diversifies a portfolio along the yield curve.
The disadvantage when compared to bond funds, like ETFs and mutual funds, is that bond ladders are less diversified by issuer. Typically an investor will own one bond for each maturity, meaning they will not be protected if the issuer defaults.
Examples of bond ETFs
The iShares Core U.S. Aggregate Bond ETF (AGG) is the largest US-listed bond ETF. It tracks the Barclays Capital U.S. Aggregate Bond Index of USD government, mortgage, and corporate bonds.
The iShares 20+ Year Treasury Bond ETF (TLT) invests in US government bonds with maturities of 20 years or longer.
Investors wanting to hedge bond exposure or bet on rising interest rates can trade inverse exposure bond ETFs. An example is the ProShares Short 20+ Year Treasury ETF (TBF). It holds short positions in long term US treasury bonds.
The iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks an index of liquid, investment-grade corporate bonds. The fund is well-diversified across 2,327 different bonds.
The J.P. Morgan USD Emerging Markets Bond ETF (EMB) is a popular fund amongst emerging market investors. The fund holds over 650 government bonds from over 15 countries.
Advantages of bond ETFs
• Bond ETFs offer investors a simple way to invest in the bond market.
• Most bond ETFs are diversified across a large number of bonds and issuers.
• Adding bond exposure to a portfolio reduces overall volatility.
• Bond ETFs can be used to speculate on interest rate movements.
Disadvantages of bond ETFs
• While bonds pay out the full face value at maturity, capital losses may be realized in a bond ETF.
• While interest rates are very low, bond ETFs may not offer large enough returns to justify the risk of rising rates.
Recommended ETF Broker
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.