Bond ETFs are one of the newest additions to the huge ranges of funds that investors can use to build their portfolios. These are Exchange Traded Funds that are known to provide a lot of benefits to investors, often providing them with a substantial extra income. But like all investment opportunities, ETF’s come with many risks as well.
Here is everything you need to know about investing in ETFs, so you can decide whether this is the right investment opportunity for you.
What is a bond ETF?
A bond ETF is an exchange-traded fund that owns a bond portfolio. An ETF frequently tracks a specific index of securities such as bonds, making it a passively managed investment rather than actively managing a bond portfolio to beat a benchmark index.
Bond ETFs come in a variety of shapes and sizes, including funds that try to represent the whole bond market as well as funds that slice and dice the bond market into specialized segments like investment-grade or short-term bonds.
Bond ETFs, like stocks, are traded on the stock exchange and can be traded at any time the market is open. Bond ETFs are extremely liquid, unlike many bonds, allowing you to save money.
How expensive are ETFs?
Bond ETFs, like all other ETFs, have an expense ratio to cover the costs of operating and profiting from the fund. For investors, the good news is that these costs have been heading down for quite some time.
The asset-weighted average cost ratio for an index bond ETF in 2020 was 0.13 percent, or around $13 for every $10,000 invested, according to the Investment Company Institute’s (ICI) 2021 Investment Company Fact Book. This is down from 0.26 percent in 2010, which is a definite improvement.
If you’re looking to invest in a bond ETF, opt for one with a low expense ratio so you can retain more of the profit rather than sending it to the fund company.
How to buy an ETF
ETFs are quite simple to purchase these days, and they trade on the stock market just like any other stock. They are just like stocks in that you may place, buy, and sell orders on them, and they’re available for trading on any day the market is open, making them liquid.
Even better, commission-free trading is now available at practically every major online brokerage, so investing in a bond ETF won’t cost you anything more.
Bond ETFs vs Bond mutual funds
Bond ETFs differ from bond mutual funds in certain ways, yet they accomplish many of the same goals. Both provide diversified bond exposure and may allow you to buy a specific part of the market. They also have a reputation for charging inexpensive fees. Here are some important distinctions:
- Tax differences – ETFs are more tax-efficient than mutual funds. This is because mutual funds will pay capital gains distributions at the end of every year which creates a capital gains tax liability. This happens even if you do not sell the fund.
- ETF trading time – Like normal security ETFs trade during the day on the stock market, while mutual funds only trade after the price has been settled at the end of the trading day. This is where ETFs have the advantage, as you will know exactly what the price of the RTF will be, while you will have to wait for the price of a mutual bond.
- Mutual funds are cheaper – on average mutual funds charge an asset-weighted average of 0.06%, which is higher than the ETF charge of 0.13%.
- BUT managing mutual bonds is more expensive – ETFs are passively managed, so they are cheaper than the actively managed bond mutual funds, which averaged 0.50% in 2020.
- ETFs have no minimum investment requirement (usually) – You can get an ETF for the cost of one share, or however, much your broker allows you to purchase fractal shares. Mutual funds are much more expensive, often requiring you to make an investment that can cost a few thousand dollars at least.
Pros and cons of ETFs
Like all investment opportunities, ETFs come with their own advantages and disadvantages when it comes to investing. Here are a few.
A bond ETF distributes the interest it earns on the bonds it owns. As a result, a bond ETF can be an excellent method to build up an income stream without having to worry about individual bonds maturing or being redeemed.
A bond ETF can provide rapid diversification throughout your entire portfolio as well as inside the bond segment. As a result, if you add a bond ETF to your portfolio, your returns will be more resilient and consistent than if you simply had equities in your portfolio. Diversification reduces risk in most cases.
Some of the most popular bond ETFs pay monthly dividends, providing investors with consistent income over a short period of time. This means that investors can use the regular dividends from bond ETFs to create a monthly budget.
If you want to buy a bond ETF, you’ll have to pay the price of a share (or even less if you use a broker that allows fractional shares). And that’s a lot better than the customary $1,000 minimum for buying a single bond.
Make bond investing more accessible
The bond market, in comparison to the stock market, can be secretive and lack liquidity. Bond ETFs, on the other hand, are traded like stocks on the stock exchange and allow investors to add and exit holdings swiftly. Liquidity may be the single most essential feature of a bond ETF for individual investors.
Cheaper than buying bonds
Bond markets are less liquid than stock markets, with far wider bid-ask spreads that cost money to investors. By investing in a bond ETF, you can take advantage of the fund company’s buying power to get better bond prices, cutting your own costs.
In your bond portfolio, you can have a short-term bond fund, an intermediate-term bond fund, and a long-term bond fund. When added to a stock-heavy portfolio, each will react differently to interest rate variations, resulting in a less volatile portfolio. Investors benefit from this since they may pick and choose whatever market segments they want to invest in.
This potential downside of bond ETFs is due to interest rates rather than the ETFs themselves. Rates are projected to remain low for some time, especially for shorter-term bonds, and bond expense ratios will exacerbate the situation.
When you buy a bond ETF, the bonds are often chosen by passively matching an index, so the rates are likely to reflect the bigger market. An actively managed mutual fund, on the other hand, may bring some additional benefits, but you’ll most likely have to pay a higher cost ratio to invest in one. However, the additional expenditure may be justified in terms of improved returns.
High expense ratios
The expense ratios — the fees that investors pay to a manager to administer the fund — are one problem with bond ETFs. Because interest rates are so low, a bond fund’s fees may eat up a large portion of the money generated by its holdings, reducing a little yield to almost nothing.
No guarantees of principle
When you invest in the stock market, there are no guarantees that your money will be safe. If interest rates climb against you, you could lose a lot of money if you invest in the wrong bond fund. As interest rates rise, long-term funds, for example, will be affected more than short-term funds.
No one will reimburse you if you have to sell a bond ETF while it is down in value. As a result, a CD may be a better alternative for some savers because the FDIC protects the principal up to a limit of $250,000 per person, per account type, at each bank.
Is investing in Bond ETFs worth it?
Like all investment opportunities, bond ETFs come with their own risks and rewards. Bond ETFs can help investors diversify their portfolios quickly by allowing them to buy just one or two securities. Investors must, however, evaluate the disadvantages, such as a high expense ratio, which could eat into returns in this low-interest-rate environment.
With all investing, the more research you do on the topic the better. Make sure that you understand exactly what you can afford to buy, and what you can afford to potentially lose. But so long as you are careful with your money, bond ETFs are a good investment plan.