Unlike bonds that are traded over the counter, bond ETFs are traded throughout the day in major centralized exchanges. Bond ETFs are more liquid than stocks as well as individual bonds due to their transparent nature. They are available on a global basis.
Quick Insights
What is bond ETF?
Bond ETF is an Exchange Traded Fund, that consists of a portfolio of bonds or treasuries. Investors need to understand the risks exposed to interest rate changes before entering into the bond market.
Since the assets held by bond ETFs have different maturity dates and different interest rates, the coupon payout by the bond ETFs differs every month.
Whether to purchase a bond or a bond ETF depends upon the financial goal of the investor. Rather than long-term investors, bond ETFs are the ideal choice for traders who buy and sell more frequently. Bond prices have an inverse relationship with interest rate changes. When interest rates rise, bond prices fall, and vice versa.
Bonds ETFs are exposed to two types of risks, namely credit risk and interest rate risk.
- Credit risk involves the possibility of default by the borrower resulting in non-payment of interest and principal.
- Interest rate risk, as its name implies, affects the value of bond ETFs while rising. There are also other risks in bonds and bond ETFs, such as low liquidity, rising inflation, etc.
Types of bond ETFs
Bond ETFs fall under the below 4 categories. They are,
Sovereign bond ETFs
These are high-quality bond ETFs, issued by the government to raise funds for various operations and other national needs. This is the primary source of government financing and one of the safest of all bond ETFs. Types of sovereign bonds include US treasury ETFs, Treasury Inflation-Protected Securities ETFs (TIPS), Mortgage-Backed Securities (MBSs), and International Bond ETFs.
Municipal bond ETFs
These are tax-free bonds issued by the local and federal governments to raise funds for infrastructure development and education. Since the local governments don’t default, municipal bond ETFs are also considered one of the safest investments among the bond ETFs.
Corporate bond ETFs
These are high-return bonds issued by corporations to raise capital for financing their operations. In case of bankruptcy, companies pay off debts first and that is why corporate bond ETFs are also safe options.
A few types of corporate bonds include Investment grade ETFs, Junk bond ETFs, Hybrid Security ETFs, and Senior bank loan ETFs.
Broad market ETFs
Broad market ETFs are a blend of sovereign, municipal, and corporate debts together. The types of broad market ETFs are Money Market Alternatives, Leveraged/Inverse ETFs, and Unconstrained/Tactical bond ETFs.
Are bond ETFs a good investment?
Bonds usually play a key role in portfolio diversification thereby helping investors to balance the risk of any negative equity returns. Investing in bond ETFs is at risk only when the borrower defaults. Though bonds and bonds ETFs have similarities, the holdings and the fees vary. Moreover, bond ETFs don’t mature, and hence the principal is not guaranteed.
Benefits of bond ETFs
Diversification:
Bond ETFs are the perfect choice for investment diversification of your portfolio as they offset the negative returns of the other assets and provide steady returns.
Easy to manage:
Bond ETFs are easy to buy and sell. It is less complicated to manage bond ETFs that pay out interest and dividends on an agreed regular basis. Redemption of the individual bonds is also easy to carry out.
Stable Income:
Bond ETFs generate interest income on the bond assets and hence provide investors with regular monthly payouts.
Transparency:
Investors don’t need to research the individual bonds, instead they can choose their desired bonds using ETFs. Buying ETFs is cheaper than buying individual bonds and stocks.
Liquidity:
Though the bond market lacks liquidity unlike the stock market, bond ETFs are traded similarly to the stocks, providing smooth exit and entry.
Lower Fees:
The passive management structure of bond ETFs makes the fees lower than that of bonds.
Should I invest in bonds now?
Provided the strong economic growth and persistent inflation, it is surely the right time to invest in bonds. There are promising economic factors to give hope that the Fed will not cut interest rates this year.
In order to manage the short-term interest rate volatility before the Fed’s action on interest rates, investors should focus on intermediate-term bonds or ETFs.
Conclusion
Bond ETFs have both pros and cons. Yet, bonds or bond ETFs remain a must-have asset in every investor’s portfolio as investors tend to reduce downside risks by diversifying their portfolios. Short-term interest rates remain high and provide compelling yields and hence it is now the right time to invest in bond ETFs.
Pro Tip
Learn more about bond ETFs and their exposure to interest rates and other influencing factors with Trading Critique. With us, one can also explore other investment opportunities on crypto, CFDs, stocks, trusted forex brokers related reviews, and more.
Frequently asked questions
1. Why do bond ETFs go down when interest rates rise?
When the interest rate increases, the fixed rate paid by the bonds becomes less valuable, bringing the bond prices down.
2. What is Bloomberg US corporate fund?
This is a fund that tracks a Bloomberg Barclays Index and measures the performance of investment grade, fixed-rate, corporate bond market.
3. How do bond investments pay dividends?
Usually, bond ETFs pay out interest on a monthly basis and they pay capital gains or dividends on an annual basis.
