Bond ETFs: A Viable Alternative

While some electronic bond trading is available to retail investors, most bonds are traded on an over-the-counter market. Unlike stock trading - for which automation has leveled the playing field for retail and institutional investors - the bond market lacks liquidity and price transparency except for the most liquid of bonds. For the self-directed bond investor, for whom it may make little sense to invest in expensive actively managed bond funds, exchange-traded funds (ETFs) that track bond indices may offer a good alternative.

Overview of Bond ETFs

While similar to other ETFs, bond ETFs are unique in the world of fixed income because, as they are traded on stock exchanges, the current and historical prices of bond ETFs are available to all investors. Historically, this kind of price transparency for bonds has been available only to institutional investors.

The challenge for the architect of a bond ETF is to ensure that it closely tracks its respective index in a cost-effective manner, despite the lack of liquidity in the bond market. Most bonds are held until maturity, so the secondary market may not be very active and lack an availability of buyers and sellers. This makes it difficult to ensure a bond ETF encompasses enough liquid bonds to track an index. This challenge is bigger for corporate bonds than for government bonds.

The suppliers of bond ETFs get around the liquidity problem by using representative sampling, which simply means tracking only a sufficient number of bonds to represent an index. The bonds used in the representative sample tend to be the largest and most liquid in the index. Given the liquidity of government bonds, tracking errors will be less of a problem with ETFs that represent government bond indices.

Bond ETFs pay out interest through a monthly dividend, while any capital gains are paid out through an annual dividend. For tax purposes, these dividends are treated as either income or capital gains. However, the tax efficiency of bond ETFs is not a big factor, because capital gains do not play as big of a part in bond returns as they do in stock returns. Finally, bond ETFs are available on a global basis.

Types of Bonds in Bond ETFs

Very generally speaking, you'll come across three types of bonds within a bond ETF. The composition of these three types of bonds (or inclusion of other types of fixed-income securities) will depend on the specific bond ETF.

Federal Government Bonds

One significant category within bond ETFs comprises government bonds. These bonds are issued by national governments and are considered among the safest fixed-income instruments (as it's assumed the issuing government entity is not near defaulting). Governments issue bonds to raise funds for public consumption or special initiatives.

Corporate Bonds

Another crucial component of bond ETFs is corporate bonds. These are debt securities issued by corporations to raise capital. Corporate bond ETFs can widely range in creditworthiness, with companies with stronger credit and outlook being more secure and companies with going concerns being much more risky.

Municipal Bonds

Similar to federal government bonds, municipal bond ETFs provide exposure to the debt issued by government entities to fund public projects. Investors are drawn to municipal bonds for potential tax advantages, as the interest income may be exempt from federal and, in some cases, state taxes. Again, in many contexts, municipal bonds are considered safer than corporate bonds.

Bond ETFs vs. Bond Ladders

The liquidity and transparency of an ETF offers advantages over a passively held bond ladder. Bond ETFs offer instant diversification and a constant duration, which means an investor needs to make only one trade to get a fixed-income portfolio up and running. A bond ladder, which requires buying individual bonds, does not offer this luxury.

One disadvantage of bond ETFs is that they charge an ongoing management fee. While lower spreads on trading bond ETFs help offset this somewhat, the issue will still prevail with a buy-and-hold strategy over the longer term. The initial trading spread advantage of bond ETFs is eroded over time by the annual management fee.

The second disadvantage is that there is no flexibility to create something unique for a portfolio. The ETF's portfolio manager decides the mix of bonds to hold, or else is beholden to an established index of bonds that already exists.

Bond ETFs vs. Index Bond Funds

Bond ETFs and index bond funds cover similar indices, use similar optimization strategies and have similar performance. Bond ETFs, however, are the better alternative for those looking for more flexible trading and better transparency. The make-up of the underlying portfolio for a bond ETF is available daily online, but this type of information for index bond funds is available only on a semi-annual basis. Furthermore, on top of being able to trade bond ETFs throughout the day, active traders can enjoy the ability to use margin, sell short, and trade options on these securities.

The main disadvantage of bond ETFs is the trading commissions they generate. Therefore, they make more sense for larger and less frequent trades. However, ETFs don't pose this disadvantage for investors who purchase their index bond funds through a third party (such as an online broker), which also charges a fee for the fund trade.

Bond ETFs. vs. Bond Mutual Funds

Both bond ETFs and bond mutual funds provide investors fixed-income exposure. However, they are mechanically different. Bond ETFs trade on stock exchanges throughout the day at market prices. This intraday trading highlights ETF flexibility. On the other hand, bond mutual funds are bought or sold at the end of the trading day at the net asset value (NAV). This key distinction means that investors in bond mutual funds may not have the same intraday trading opportunities as those in bond ETFs.

The management styles of bond ETFs and bond mutual funds also vary. Bond ETFs are often passively managed, aiming to replicate the performance of a specific bond index. In contrast, bond mutual funds may be actively managed, with portfolio managers making decisions to outperform the market. Though this usually means higher fees, it also means potentially higher returns (before the fees).

Bond ETFs vs. Equity ETFs

Bond ETFs and stock ETFs are distinct investment vehicles with somewhat different goals. Bond ETFs are considered lower-risk investments, offering more predictable returns through interest payments. They are particularly attractive to investors seeking income and capital preservation, making them great for retirees or those wanting to be more conservative. On the other hand, stock ETFs generally involve higher risk and the potential for higher returns.

Both types of investments may have an income component. Investors in stock ETFs may benefit from dividend income paid by the underlying companies. Note that companies are not obligated to continue to pay dividends like they have in their past, unlike the fixed coupon rate for a bond for the entirety of its life.

Bond ETFs face credit risk associated with the issuers of the underlying bonds, whereas stock ETFs are not directly exposed to credit risk but are influenced by business and market-related risks. In other words, bond ETFs are at risk if the borrower defaults as this means they may not pay the entire amount of the bond back. While there is no debt to an equity ETF, the underlying companies can still incur losses and lose value.

Investors often use a combination of both bond and stock ETFs to achieve a diversified portfolio. You can do this if you want to balances risk and return. Bond ETFs are favored by those seeking stability and income, while stock ETFs are chosen by those aiming for growth and willing to accept higher market volatility.

The Bottom Line

Bond ETFs offer an excellent alternative for self-directed investors who, looking for ease of trading and increased price transparency, want to practice indexing or active bond trading. However, bond ETFs are suitable for particular strategies. If, for instance, you are looking to create a specific income stream, bond ETFs may not be for you. Be sure to compare your alternatives before investing.