The pros and cons of bond ETFs

3 min read

Are you a yield chaser?

If so, you’ve probably noticed short-term bond exchange-traded funds, or ETFs, are where some people are parking their money.

An ETF tracks a market, sector or index but can be traded like a stock. Like money market funds, these ETFs typically invest in high-quality, short-term securities like Treasuries. But there are some noteworthy differences. You can lose principal, and the funds aren’t insured by the Federal Deposit Insurance Corp.

That’s not all. Most of these ETFs are new kids on the block — usually only a few years old — and don’t have substantial track records yet. More ETFs are reportedly in the pipeline.

The upshot: Be careful that you don’t trade investing safety for slightly higher yields.

“These ETFs are a new concept,” says Pete Crane, president of Crane Data of Westborough, Mass. “But nothing substitutes for money markets (as safe investments). There’s no free yield.”

If you must stay liquid, short-term bond ETFs may not be right for you. “But if you’re adding income to a structured portfolio and can tolerate modest losses, they’re appropriate,” Crane says.

Typically, this brand of ETF holds ultra short-term bonds with maturities usually from one to three months. But they can be up to one year. The best ones combine high-quality bonds from well-known brand names. They include offerings from big ETF-fund companies such as iShares in Jersey City, N.J., PIMCO in Newport Beach, Calif., and State Street Corp. in Boston.

Expense ratios, which can drag down returns, vary widely. For example, the iShares Barclays Short Treasury Bond Fund mirrors the Barclays Capital U.S. Short Treasury Bond Index. Much of its almost $4 billion in assets are parked in Treasuries. But its expense ratio, which measures fund-operating expenses annually, is only 0.15 percent. Conversely, the PIMCO Enhanced Short Maturity Strategy Fund has a 0.35 percent expense ratio.

Another ETF, the SPDR Barclays Capital 1-3 month T-Bill ETF, has a 0.13 percent expense ratio. “It’s lower than money markets, on average,” says Tom Anderson, global head of ETF strategy and research at State Street Global Advisors in Boston.

Here are the pros and cons to consider before making a leap into bond ETFs.

The pros:

  • They are highly liquid. Since ETFs trade like stocks, you can sell them to move into a cash position any time during the day. “The ETF is always open,” says Crane, adding that it’s an advantage for heavy day traders who are quickly in and out of stocks.
  • You have lots of options. Short-term ETFs run the gamut from low-risk Treasuries to high-yield bonds. Some ETFs, such as the WisdomTree Dreyfus Euro Fund and WisdomTree Dreyfus Chinese Yuan Fund, invest in foreign currencies.

“Rates outside the U.S. are a lot higher,” says Michael Johnston, senior analyst at ETF Database in Chicago. “But there is an additional layer of risk. If you want higher returns, get out of the money market sandbox.”

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.