What is a Bond ETF?
Bond exchange-traded funds are comparable to stock exchange-traded funds in the way that they are passively managed and traded on the stock exchanges. Individual bonds and mutual funds trade at one price (NAV) each day after the market closes. While these ETFs are more liquid since they trade on the exchange during market hours.
Thus, these exchange-traded funds are a low-cost solution for investors to have passive exposure to benchmark bond indices.
Types of Bond ETFs
There are different kinds of bond exchange-traded funds based on term, yield, etc. Following are the types of bond exchange-traded funds:
- Short-term bond ETFs: These have a maturity of less than a few years. Thus, they do not fluctuate significantly in response to interest rate fluctuations.
- Medium-term bond ETFs: These have a maturity of up to 10 years. The yield is higher than short term bonds and also are more sensitive to interest rate movements.
- Long term bond ETFs: These have a maturity of up to 30 years or more. These bonds pay higher interest rates than shorter-term bonds. Furthermore, the ETFs are highly responsive to interest rate movements.
- Total bond market ETFs. These ETFs have exposure across different maturities – short, medium and long term. Thus, these are diversified ETFs and are not skewed in one direction.
- Investment-grade bond ETFs: These ETFs invest across bonds with high ratings. Thus, they are safer investment options. Investment-grade bond exchange-traded funds pay less than lower-quality bonds (high yielding bonds)
- High-yield BondETFs: These are also known as junk bond ETFs. They do not invest in bonds with high ratings, thus making them a risky investment option. As a result, the ETF pays higher yields.
- Municipal BondETFs: These exchange-traded funds hold bonds issued by states. Thus, they are tax-efficient investments.
- Corporate BondETFs: These exchange-traded funds hold bonds issued by corporations.
How do Bond ETFs Work?
Bond exchange-traded funds are passive funds that invest in bonds in the same way that traditional bond mutual funds do. However, unlike typical open-ended bond mutual funds, bond ETFs trade on the stock exchange. Thus, investors can buy and sell ETFs easily. Furthermore, these ETFs have significantly low costs than actively managed funds.
Bond exchange-traded fund, like equities ETFs, aim to track the benchmark index as closely as possible. Majority of these ETFs track indexes that follow a specific segment. For example, government, corporate, or public sector bonds. These ETFs also try to track specific maturity buckets, such as short, medium, and long term bonds.
Furthermore, there are bondETFs with specific maturities as well, 3 years, 5 years and 10 years. The specific maturity bond ETFs are known as target maturity bond ETFs. These are similar to fixed maturity plans. However, they have the advantage of liquidity.
Who Should Invest in Bond ETFs?
Bond ETFs, like most fixed-income securities, are a low-risk investing option. As a result, these ETFs are appropriate for those who do not wish to take too much risk exposure. Since these ETFs trade on the stock exchanges, they offer good liquidity.
Furthermore, these ETFs can have specific maturities. Thus, on the basis of your investment horizon, you can pick a suitable bond ETF. In other words, if you have a short term investment horizon, you can choose to invest in a short term bond ETF or a 3 year specific maturity bond ETF. Therefore, these ETFs are suitable for long term medium term and short term goals.
These ETFs hold assets with different maturity dates. As a result, they pay interest every month, with the value of the coupon varying from month to month. This is because the assets the ETF holds are expected to be due for a coupon payment at any time.
These ETFs pay out interest in the form of a monthly dividend and capital gains in the form of annual payouts.
Therefore, if you are an investor with low-risk tolerance levels and wish to get regular income from your investments, you can consider investing in bond exchange-traded funds.
Things to Consider as an Investor
Following are the things to consider while investing in bond exchange-traded funds:
Understand the investment objective of the bond exchange-traded fund before investing in them. When selecting a bond ETF, you should have a clear investment strategy in mind. Choosing the right bond exchange-traded fund aligns with your investment purpose, and tenure is critical.
An investor’s investment is at greater risk in a bond exchange-traded fund than in a single bond. This is because a bond exchange-traded fund never matures, and thus uncertainty of principal repayment is high. Furthermore, when interest rates rise, the ETF’s price tends to fall like the price of an individual bond.
Bond ETFs have lower costs than actively managed bond mutual funds since tracking an index uses a passive investing method. However, when interest rates are low, these ETFs’ expense ratio tends to eat up a significant portion of the interest and thus impact the overall returns. Therefore, it is essential to consider the cost of a bond exchange-traded fund and the interest rate movements in conjunction.
Advantages of Bond Exchange-Traded Funds
Following are the advantages of investing in bond exchange-traded funds:
- Regular Income: A bond exchange-traded fund distributes the interest it earns. As a result, a bond exchange-traded fund can be an excellent source of regular income. You do not have to worry about the maturity and redemption of individual bonds. Furthermore, some popular bond ETFs pay monthly dividends.
- Real-Time Prices: Bond exchange-traded funds are listed on the stock market. Thus you can buy and sell them any time during the trading hours.
- Low Cost: Bond exchange-traded funds are low-cost investment schemes. Bond markets are less liquid than stock markets. Therefore, it is often difficult to trade in bonds. However, with bond exchange-traded funds, you can easily invest in bonds.
- Diversification: Bond exchange traded funds offer good diversification to your investment portfolio. These exchange-traded funds give exposure to different bonds based on the type. As a practice, having some debt exposure is healthy for your investment portfolio.
- Passively Managed Funds: Bond exchange-traded funds are passively managed schemes. The fund aims to track the performance of the underlying bond index closely.