Portfolio Management | January 28, 2020

The Nuts and Bolts of Bond ETFs

In the past, investors looking for steady income and portfolio diversification tended to buy individual bonds. However, the rise of bond exchange-traded funds (ETFs) has given investors new ways to access the fixed income market.

Like other ETFs, many bond ETFs offer broadly diversified exposure to entire segments of the market in a single investment. Bond ETFs are often a lower-cost alternative to individual bonds, which can be expensive to trade. These funds also trade intraday on an exchange just like stocks.

As you can see in the chart below, inflows into bond ETFs have been on the rise.

Source: Morningstar Direct, data from 01/01/2010 through 12/31/2019. The dip in inflows in 2013 reflects the selloff that hit bond markets in 2013 after the Federal Reserve announced it would begin to scale back its Treasury bond purchases, an event often called the “taper tantrum.”

Bond ETFs have unique attributes that may or may not be a good fit for every investor. It’s important to understand how they work and what to consider when selecting one of these funds.

How they work

Like most ETFs, bond ETFs seek to track an index of underlying investments. Some track very broad indexes of investment-grade bonds—or those rated from Aaa to Baa3 by Moody’s, or AAA to BBB by Standard & Poor’s—such as the Bloomberg Barclays U.S. Aggregate Bond Index. Others might track foreign bonds, corporate bonds, municipal bonds or high-yield bonds.

The value of a bond ETF rises and falls each day based on the value of the underlying bonds in the index. These fluctuations can confuse many first-time bond ETF investors.

Unlike individual bonds that pay back the face value at maturity (barring default), most bond ETFs don’t “mature,” so an investor would have to sell his or her ETFs to cash out. If the value of the underlying bonds in the ETF has dropped since he or she bought it, the ETF may also be worth less, meaning the investor could be in for a loss. In other words, the principal guarantees investors might expect from a bond don’t apply with bond ETFs.

Finally, bond ETFs provide income in the form of a dividend, typically monthly, while capital gains (if any) are distributed by way of an annual dividend.

Types of bond ETFs

Of course, not all bond ETFs are alike. The three most popular types are core bonds, corporate bonds and high-yield bonds.

  • Core bonds. The biggest ETFs in the bond world, at least in terms of assets, are those that track broad U.S. indexes like the Bloomberg Barclays U.S. Aggregate Bond Index. This index is heavily weighted toward U.S. government-related bonds, such as Treasury bonds, agency bonds and mortgage-backed bonds. About a quarter of the index is made up of investment-grade corporate bonds.1 ETFs tied to this index tend to be large, liquid and low-cost.
  • Corporate bonds. Most corporate bond ETFs focus on investment-grade bonds. These bonds tend to pay higher interest rates than Treasuries, but carry some risk of default.
  • High-yield bonds. Riskier bonds go by several names—high-yield bonds, sub-investment-grade bonds or junk bonds. Such bonds are issued by companies, countries or municipalities that credit-rating agencies believe carry a higher risk of default. As the name “high-yield” implies, these bonds offer investors higher returns in exchange for the increased risk. High-yield bonds are usually some of the hardest bonds to trade, with many not trading at all most days.

There are many other varieties of bond ETFs out there. For example, you can find ETFs that hold Treasury Inflation-Protected Securities (TIPS), which are government bonds whose ultimate payouts rise with the rate of inflation. Target maturity bond ETFs hold bonds that all mature in the same year, after which the ETF liquidates and returns cash to shareholders. And municipal bond ETFs hold bonds issued by states, cities and territories. The interest is typically exempt from federal and sometimes state income taxes. You can also find ETFs that hold bonds issued overseas, sometimes in foreign currencies.

Bond ETF risks

Broadly speaking, bond ETFs combine some of the risks inherent in both bonds and ETFs and it’s important to understand them before investing.

  • Interest-rate risk. This refers to the potential for a bond to lose value if interest rates rise. In general, the longer a bond has until maturity, the more sensitive its value is to changes in rates. This affects all bonds, but the dynamics are a little different for bond ETFs. Remember, bond ETF prices are based on the market value of the underlying securities, so if rates rise and bond prices fall, the value of an ETF holding those bonds will also fall. If you decide to sell a bond ETF after a rate hike, you could suffer a loss. On the other hand, returns from bond ETFs come from both dividends and price changes. Higher interest rates generally boost dividends, which could help offset price losses over time.
  • Credit risk. This is the possibility that a bond issuer will fail to pay the interest and/or principal it owes to bondholders. If the issuer defaults, bondholders may not get anything. Defaults can drag down the price of ETFs that hold that bond. High-quality bonds like U.S. Treasuries might have little to no credit risk, while high-yield bonds from low-rated companies could have a great deal.
  • Liquidity risk. This refers to the risk that a lack of trading opportunities could make it more difficult to execute a trade at a desired price. When a market becomes less liquid and it’s hard to trade the underlying investment, it becomes hard to trade the ETF, too. ETFs that own the least-liquid types of bonds (for example, high-yield and emerging market bonds) are at the highest risk of illiquidity in a crisis. If you try to sell these ETFs while markets are volatile, the price you get might be lower than what the underlying bonds are worth at that moment.
  • Tracking error risk. This refers to differences between the performance of an ETF and the index it’s designed to track. A high degree of tracking error means an ETF’s performance is significantly different from its benchmark index, which could signal the fund manager’s strategy isn’t working as planned. This can be a problem for investors because their returns may differ from what they might expect based on the performance of their index. It can be tough for bond ETFs to fully replicate the performance of some bond indexes because many of the underlying bonds can’t be traded easily. In such cases, the fund manager will substitute more liquid fixed income securities that share the same risk and return characteristics as the illiquid bonds in the index. Such substitutions could potentially increase tracking error.

Bond ETFs can be a convenient way to access the bond market—whether you’re seeking diversified exposure to the highest-rated bonds or a particular niche within the market—with very low ongoing expenses. Just be sure to keep in mind the risks of the bonds themselves and the unique risks ETFs bring to trading and portfolio management.

 

1 Bloomberg Barclays U.S. Aggregate Bond Index Fact Sheet, 2/8/2017.

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