Bond ETFs are a welcome addition to the range of funds that investors have at their disposal in building a portfolio. These exchange-traded funds bring a lot of benefits, and while they solve many pain points for investors, they’re not without some drawbacks, too.
Here’s what you need to know about the pros and cons of bond ETFs.
The pros and cons of bond ETFs
1. Immediate diversification and lower risk
One of the key benefits of a bond ETF is that it can provide you immediate diversification, both across your portfolio and within the bond portion of your portfolio. So, for example, by adding a bond ETF to your portfolio, your returns will tend to be more resilient and stable than if you had a portfolio consisting of only stocks. Diversification usually leads to lower risk.
But even within the bond portion of your portfolio you can have different kinds of bond ETFs, such as a short-term bond fund, an intermediate-term fund and a long-term fund. Each will respond differently to changes in interest rates, and generally will create a less volatile portfolio if added to a stock-heavy portfolio.
2. Portfolio construction
Bond ETFs can come in a variety of forms, including funds that aim to represent the total market as well as funds that slice and dice the bond market into specific parts – investment-grade or short-term bonds, for example. That’s valuable for investors, because they can select exactly the segment of the market that they want to own. Want only a slice of intermediate-term investment-grade bonds or a swath of high-yield bonds? Check and check.
So rather than having to investigate a variety of individual bonds, investors can select the kinds of bonds they want in their portfolio and then “plug and play” using the ETF they want. That also makes bond ETFs an ideal solution for financial advisers, including robo-advisers, who need to fill out a client’s diversified portfolio with the right level of risk and return.
Another great aspect of bond ETFs is that they actually make bond investing more accessible to individual investors. The bond market can be somewhat opaque, relative to the stock market, with wide bid-ask spreads and a lack of liquidity. In contrast, bond ETFs are traded on the stock market like a stock, and offer investors the ability to move in and out of a position quite easily.
It might not seem like it, but liquidity may be the single largest advantage of a bond ETF for individual investors.
4. Expense ratios
If there’s an area where bond ETFs have drawbacks, it could be in their expense ratios – those fees that investors pay for the manager to handle the fund. With interest rates so low, a bond fund’s expenses may eat up a sizable portion of the interest generated by the holdings, turning a small yield into a miniscule one.
But the numbers have been moving in the right direction for investors for some time. In 2019, the asset-weighted average expense ratio for an index bond ETF was 0.14 percent, or about $14 per $10,000 invested, according to the Investment Company Institute’s 2020 Investment Company Fact Book, a compendium on the industry. That’s down from 0.26 percent in 2010.
Typically, stock ETFs are cheaper than mutual funds, but in the case of index bonds funds, it’s the reverse. Index bond mutual funds charged an asset-weighted average of 0.07 percent in 2019, according to the Investment Company Institute, lower than the comparable bond ETF. (Actively managed bond funds, however, averaged 0.56 percent in 2019, says the report.)
If you’re looking for a bond ETF, search for funds with lower expense ratios, so that you put more of your fund’s yield into your own pocket instead of the fund company’s.
5. Low returns and no guarantees of principal
Another potential downside with bond ETFs has less to do with them than with interest rates. Rates will likely remain low for some time, especially for shorter-term bonds, and that situation will only be exacerbated by the expense ratios on bonds.
If you’re buying a bond ETF – where the bonds are usually selected by passively reflecting an index – yields are likely to reflect the broader market. However, you may get some extra juice from an actively managed mutual fund, but you’ll probably have to pay a higher expense ratio to get into it. That higher expense may be worth it, however, in terms of higher returns.
In addition, if interest rates turn against you, the wrong kind of bond fund may decline a lot. For example, long-term funds will be hurt more by rising rates than short-term funds will be. When investing in the market, there are no guarantees on your principal. If you have to sell when the bond ETF is down, no one will pay you back for the decline.
So sometimes, a CD might be a better option for certain savers, because its principal is guaranteed against loss by the FDIC up to a limit of $250,000 per person, per account type.
How to buy an ETF
ETFs are tremendously easy for investors to purchase these days, and they trade on the stock market just like a regular stock. You can place buy and sell orders on them exactly as you would for a stock, and they’re available for trading on any day the market is open, making them liquid.
Even better, these days investors can access commission-free trading at virtually every major online brokerage, so it doesn’t even cost you any extra money to get into a bond ETF.
Bond ETFs really can provide a lot of value for investors, allowing them to quickly diversify a portfolio by buying just one or two securities. But investors need to minimize the downsides such as a high expense ratio, which can really cut into returns in this era of low interest rates.
Featured image by Witthaya Prasongsin of Getty Images.