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.
What is a bond ETF?
A bond ETF is an exchange-traded fund that owns a portfolio of bonds. Typically an ETF tracks a specific index of securities such as bonds, making it a passively managed investment, rather than trying to actively manage a bond portfolio to beat a benchmark index.
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.
Bond ETFs trade on the stock exchange just like stocks, meaning that you can trade them whenever the market is open. Bond ETFs are highly liquid, unlike many bonds, helping to reduce your costs.
The pros and cons of bond ETFs
Pros of bond ETFs
- A bond ETF pays out the interest it receives on the bonds in its portfolio. So a bond ETF can be a good way to set up an income stream without having to worry about the maturity and redemption of individual bonds.
- Monthly dividends. Some of the most popular bond ETFs pay dividends monthly, giving investors regular income on a short timeframe. This means investors can figure a monthly budget using the regular payouts from bond ETFs.
- Immediate diversification. A bond ETF 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.
- Targeted exposure to bonds. 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 creates a less volatile portfolio if added to a stock-heavy portfolio. 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.
- No need to analyze individual bonds. 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 advisors, including robo-advisors, who need to fill out a client’s diversified portfolio with the right level of risk and return.
- Cheaper than buying bonds directly. Generally, the bond market is not as liquid as the stock market, with often much wider bid-ask spreads that cost investors real money. By buying a bond ETF, you leverage the fund company’s ability to get better pricing on its bond purchases, reducing your own expenses with the bond ETF.
- You don’t need as much money. If you’re buying a bond ETF, it will cost the price of a share to get in (or even less if you’re using a broker that allows fractional shares.) And that’s much more favorable than the typical $1,000 minimum or so to buy an individual bond.
- 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 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.
- Tax-efficiency. The ETF structure is tax-efficient, and generally passes on few, if any, capital gains to investors.
Cons of bond ETFs
- Expense ratios may be relatively high. 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.
- Low returns. 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.
- No guarantees of principal. When investing in the market, there are no guarantees on your principal. 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. 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 at each bank.
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.
How expensive are bond ETFs?
Like other ETFs, bond ETFs charge an expense ratio to cover the costs of running the fund and generating a profit. The good news for investors is that these fees have been moving in the right direction (lower) for investors for some time.
In 2020, the asset-weighted average expense ratio for an index bond ETF was 0.13 percent, or about $13 per $10,000 invested, according to the Investment Company Institute’s (ICI) 2021 Investment Company Fact Book, a compendium on the industry. That’s down from 0.26 percent in 2010.
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.
Types of bond ETFs
- Short-term bond ETFs. This type of bond ETF holds short-term bonds, often those that mature in less than a few years. These bonds don’t move much in response to changes in interest rates, helping make them lower risk.
- Intermediate-term bond ETFs. This kind of bond ETF holds intermediate-term bonds, typically those that mature between a few years and 10 years or so. This ETF typically pays more than short-term bond ETFs and can move quite a bit in response to changes in the interest rate.
- Long-term bond ETFs. This type of bond ETF holds long-term bonds, often with maturities of 30 years or longer. Because of their longer term, these bonds usually pay a higher interest rate than shorter-term bonds. This kind of bond is very responsive to changes in interest rates, moving up when rates fall and sinking when rates rise.
- Total bond market ETFs. This bond ETF gives investors exposure to bonds across the spectrum of maturities – short, intermediate and long. It provides broad, diversified bond exposure without being weighted too heavily in one direction or another.
- Investment-grade bond ETFs. This kind of bond ETF invests exclusively in highly rated bonds, meaning it tends to be safer. Because of these bonds’ perceived safety, this bond ETF generally pays less than ETFs with lower-quality bonds, such as high-yield bonds.
- High-yield bond ETFs. This bond ETF invests in high-yield bonds, what formerly used to be called junk bonds. The quality of the bonds in this kind of ETF ranges from decent to potentially terrible, depending on the issuer. Because of the perceived riskiness of its bonds, this ETF typically pays a higher yield than investment-grade ETFs.
- Municipal bond ETFs. This bond ETF holds securities, typically tax-advantaged bonds, issued by states and cities. You’ll avoid federal taxes on these ETFs, but you’ll escape state taxes on this ETF only if it invests exclusively in a state where you pay taxes.
Bond ETFs vs. bond mutual funds: What’s the difference?
Bond ETFs are a bit different from bond mutual funds, but they achieve many similar things. Both offer diversified exposure to bonds, and they may allow you to buy just a targeted segment of the market. They also tend to charge low fees overall. Here are a few key differences:
- Index bond mutual funds are cheaper on average than bond ETFs. Index bond mutual funds charged an asset-weighted average of 0.06 percent in 2020, according to the ICI, lower than the comparable bond ETF of 0.13 percent.
- However, actively managed bond mutual funds are more expensive than bond ETFs, which are typically passively managed. Actively managed bond mutual funds averaged 0.50 percent in 2020, says the ICI. But you may get some extra juice in the form of higher returns for that higher fee.
- Mutual funds are generally less tax-efficient than ETFs. Mutual funds may pay capital gains distributions at the end of the year, creating a capital gains tax liability, even if you didn’t sell the fund.
- ETFs trade during the day, while mutual funds don’t. ETFs trade during the day like a normal security, while mutual funds trade hands only after their price is settled after the trading day. That means you know exactly the price you’re paying for your ETF, while you’ll have to wait and see your exact price on the mutual fund.
- ETFs generally have no minimum investment requirement. You can get started with an ETF for the cost of one share, or almost any amount if your broker allows you to purchase fractional shares. In contrast, many mutual funds require you to make an initial investment of a few thousand dollars.
Those are a few of the biggest differences between bond ETFs and bond mutual funds, but other differences between ETFs and mutual funds exist.
Bond ETFs really can provide a lot of value for investors, allowing you 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.