Updated on March 30, 2023
Bond ETFs are a great addition to any investor’s portfolio for several reasons; however, new investors still wonder, are bond ETFs a good investment? The answer typically depends on an investor’s individual goals. In this article, we’ll explore both pros and cons of bond ETFs to guide your decision on whether you should buy bond ETFs.
What is a bond ETF?
A Bond ETF refers to an exchange-traded fund holding a bond portfolio. ETFs usually track a specific index of securities like bonds, commodities, stocks, etc. Consequently, ETFs combine the flexibility of the assets such as bonds and the portfolio-diversifying benefits of mutual funds. This gives you an affordable way to invest in various asset classes.
There are many different types of bond ETFs that come in a variety of forms. For instance, some funds aim to represent the total market, while others split the market into specific focus areas.
Similar to stocks, bond ETFs are traded on stock exchanges, which means you can trade when the market is open. They are highly liquid and easily transferable, unlike many bonds.
Bond ETFs Vs. Individual Bonds
Although bond and bond ETFs may contain similar components, exchange trading of bond ETFs creates a few significant differences, as shown below;
Although individual bonds have a fixed date of maturity upon which investors receive their money, bond ETFs maintain a constant maturity which is usually the weighted average of the maturities of all the combined bonds in that portfolio. At different times, some bonds might be maturing while others might have only just started trading. Consequently, the entire portfolio’s maturity is constantly in flux.
Individual bonds are only sometimes easily tradeable, and their liquidity varies depending on a wide range of factors. On the other hand, bond ETFs enjoy a high level of liquidity because they are traded on an exchange and can therefore be bought and sold easily.
Fundamental among the important benefits of bond ETFs is the fact that investors earn a monthly income in the form of interest payouts. These coupon payments typically occur every six months, and for investors with different bond ETF investments, this could mean a regular income at different intervals throughout the year.
Bond ETFs Vs. Bond Mutual Funds
Although both bond ETFs and bond mutual funds achieve more or less the same results, a few significant differences might influence an investor’s decision to invest in one or the other.
Index mutual funds are often cheaper than bond ETFs. For instance, in 2021, index bond mutual funds charged investors an asset-weighted average of only 0.06%. Conversely, bond ETFs charged 0.12%.
However, it is essential also to remember that actively managed bond mutual funds are more expensive than bond ETFs as far as management fees are concerned. Bond ETFs are passively managed which keeps management fees down, on the other hand actively managed bond mutual funds charge high fees for their professional fund managers.
Overall, mutual funds are the less tax-efficient option of the two. Mutual funds may be forced to pay capital gains taxes at the end of the year. This would create a capital gains tax liability if the fund was not sold.
Bond ETFs are traded during the day, while bond mutual funds aren’t. ETFs are traded during the day like a normal security which increases their liquidity and makes it possible for investors to know their price at any time of the day. On the other hand, when it comes to bond mutual funds, you have to wait to confirm the exact price.
Generally, ETFs do not have a minimum investment requirement. Therefore investors can get in with an ETF cost of as little as one share or almost any amount if their broker allows the purchase of fractional shares. In contrast, mutual funds require an initial investment of about $1000.
Types of bond ETFs
This type of bond ETF holds short-term bonds– those that mature within a few years. Typically, these bonds don’t oscillate in response to interest rate changes, making them a safer investment.
This is the type of bond ETF with intermediate-term bonds, usually those with a maturity period that falls within a few years to 10 years. This ETF pays out a higher interest rate than short-term bond ETFs and responds quite a bit to interest rate changes in the market.
Bonds held within this type of bond ETF have long-term maturity dates from 10 to 30 years or longer. As a result of their long time spans, these ETFs offer high-interest rates to investors. This type of ETF is highly responsive to market interest rate changes.
Total bond market
Bond ETFs under this category offer investors exposure to bonds across the entire range of maturities- short, medium, and long. This investment provides broad, diversified exposure to the bond market without weighing heavily on one side or the other.
This type of bond ETF focuses exclusively on highly rated bonds, offering relative safety to those investors who choose to opt-in.
Bonds held within this type of ETF are popularly referred to as junk bonds/ high-yield bonds. The quality of bonds here ranges from high-quality to terrible, making this a high-risk investment. As a result of the perceived risk of this investment, these bond ETFs typically pay relatively high-interest rates.
This type of bond ETF holds securities, usually tax-advantaged bonds issued by states and cities. These are typically used by investors who wish to escape federal taxes on their ETF investments. However, tax exemptions of this kind depend on the state where your investment lies.
Should I buy bond ETFs?
The question of whether you should buy bond ETFs depends significantly on your investment goals, how much investible cash you have, and your risk appetite. However, analyzing the pros and cons of bond ETFs could help you make an informed investment decision.
Pros of bond ETFs
Easy to manage
Bond ETFs earn interest on the bonds held with the portfolio. Therefore, a bond ETF is an excellent way to create an additional income stream. It also eliminates the worry about the maturity and redemption of individual bonds.
A few of the more popular bond ETFs pay out monthly dividends, thus giving investors a regular income in a relatively short span of time. With this benefit, investors can create a monthly budget based on the expected payouts from their bond ETFs.
Bond ETFs open you up to a wide range of asset classes that were previously expensive to get into at an individual level. Your bond ETF can offer diversification across your portfolio and within the specific bond portion itself. Consequently, your overall portfolio will be more resilient and stable as your risk is lowered.
As earlier stated, the range and depth of diversification within a bond ETF are wide and provide exciting options for investors. Your portfolio can feature different kinds of bond ETFs, such as short-term, intermediate, and even long-term funds. Consequently, each type of bond ETF will attract its own interest rate and offer more safety than a typical stock-heavy portfolio.
Instead of analyzing a variety of individual bonds carefully, investors can choose the kinds of bonds they want to include in their portfolio using their ETFs. This high level of customization also makes bond ETFs perfect for financial advisors that might need to balance different options in accordance with their clients’ preferred risk/return ratio.
Bond ETFs are cheaper than purchasing individual bonds directly. As a result of the fact that the bond market is not as liquid as the stock market, bond ETFs leverage the fund company’s access to better pricing on its bond purchases, thereby reducing your own expenses compared to the alternative.
Additionally, when you’re investing in a bond ETF, it typically costs the price of a share to buy in. This is way less than the usual $1000 minimum required to invest in individual bonds.
The other advantage of bond ETFs is that they increase the accessibility of bond investing to a broader ground of individual investors. Unlike the stock market, which enjoys high transparency, the bond market can seem a bit dodgier and challenging to access for new investors.
On the other hand, bond ETFs are traded on the stock market like stocks and therefore offer new investors the opportunity to trade their positions quickly.
Cons of bond ETFs
One of the significant drawbacks of bond ETFs is the fact that their expense ratios are relatively high. Expense ratios refer to management fees paid by investors. For a bond fund, these expenses can eat up a large portion of the interest generated by the bond holdings.
Investors with high-risk appetites might be discouraged from investing in bond ETFs due to their low returns. For instance, if you invest in a bond ETF, especially one where the bonds are passively selected by tracking a specific index, yields are likely to move in the same direction as the market. Conversely, to get more from your investment, you might have to opt for an actively managed mutual fund, which, although good, attracts a higher expense ratio to participate.
Principal amount unguaranteed
Another disadvantage of investing in bond ETFs is that your principal amount is not guaranteed. If interest rates go wrong, the bond fund might be massively negatively impacted.
Bond ETFs are a valuable investment because of their numerous advantages over other asset classes. Bond ETFs might be the perfect option if you’re looking for diversity, liquidity, and a regular income. However, it is essential to research which type of bond ETF satisfies your investment goals before taking the plunge.
What is the difference between bond ETFs and individual bonds?
Bond ETFs and individual bonds may contain similar components, exchange trading of bond ETFs creates a few significant differences. Bond ETFs have a high degree of liquidity, are traded during the day, and have no minimum investment requirement, while individual bonds are not always easily tradeable, have a fixed maturity, and require an initial investment of $1000.
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