The pros and cons of bond ETFs

Tom Lydon, publisher of the website ETF Trends, likes corporate bond funds. "Lots of them have done well," Lydon says. "Corporations are flush with cash, and you get very competitive yields."

The cons:

  • You can possibly lose principal. ETF prices fluctuate, but money market funds have constant $1 asset values. "There's pressure to keep that $1 share price," Lydon says. If a Treasury-related ETF yields 1.5 percent and a money market 0.50 percent, you're getting three times the yield. But you may be giving that back, he adds.
  • Indeed, some ETFs do have negative returns. "You might be better off putting your money under a mattress," Johnston says. "ETFs aren't guaranteed to preserve capital." And volatile stock markets also mean volatile ETFs. "We saw the flash crash," Johnston says. "A lot of ETFs were subject to bizarre trading patterns."
  • Your risk varies widely. Some ETFs hold lower-quality bonds and others use leveraging, which is using borrowed money to pump up gains. That's why Lydon advises investors to know how the funds are traded. He recommends looking an ETF's 200-day moving average to identify general trends. "You have the ability to raise the caution flag," he says.

"At most financial sites, you can click on a chart," he says. "You can raise the caution flag."

Another option is to place stop-loss orders that serve as a floor.

Interest rate hikes can also ding returns. Since these ETFs hold bonds, they can get hammered if interest rates rise and share prices drop. Bond prices move inversely to interest rates. "You're buying bonds when interest rates have almost nowhere else to go but up," says Crane. "Knowing that can't be all that comforting."

The result: You could lose 1 percent to 2 percent of principal. "The danger is that investors get a minor loss, and they all run and compound the problem," says Crane. Then, the trade-off is a careful dance between secure ETFs with shorter bond maturities or ones with longer maturities but more risk but higher yields.

"If you don't know the downside risk, don't chase yields," Lydon says.

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