Bond ETF

Bond ETF (Exchange Traded Funds) is a fund that invests in various bands ranging from long-term and short-term to corporate bonds and government securities. Like a mutual fund, the Bond ETF is an exchange-traded fund that invests in a basket of bonds, including government bonds or corporate bonds. The Bond ETF is traded on the exchange, unlike bonds issued in a private placement or an over the counter market.

Investors who look for good returns at a lesser risk and want to find a source of passive income find an appropriate fit in high-yield bond ETFs as they are an inexpensive way of investing in bonds that usually have a high ticket size. However, there is an inevitable risk of interest rate fluctuation with this type of investment.

• Bond ETFs, also known as Exchange Traded Funds, invest in various types of bonds, including corporate, government, and bonds with different maturities. These funds are similar to mutual funds but trade on exchanges and invest in a range of corporate or government bonds, as opposed to private placements or over-the-counter markets.
• There are different types of Bond ETFs: Sovereign or Government Bond ETFs, Corporate Bond ETFs, and Broad Market Bond ETFs.
• Bond ETFs are traded on exchanges and typically have lower fees compared to owning actual bonds. Some Bond ETFs have a specific maturity date and are referred to as target maturity bond ETFs.

Bond ETFs are a type of Exchange Traded Funds that invest in a broad range of fixed-income securities such as treasury bonds and corporate bonds. They help investors find an inexpensive route to gain exposure passively to benchmark indices of the bond market.

iShares Investment Grade Corporate Bond is the largest Investment Grade Bond Exchange, Traded Fund.

Some short-term Bond ETFs can be an alternative to money market investment since it provides the flexibility of short and ultra-short-term fixed income ETFs.

Since the Bond ETFs are exchange-traded like stocks, it has attractive properties like stocks – annual dividends.

Bond Exchange Traded Funds can be bought and sold in the open market depending on the demand in the market for the ETF.

Bond Exchange Traded Funds have passively managed funds that invest in many fixed-income securities and are traded on an exchange. Bond ETFs charge a lower amount than the actual bond, thereby allowing investors with lower capital to invest in the bonds, which can be pricey. Some Bond ETFs have a pre-determined maturity date ranging from 3 to 10 years and are known as target maturity bond ETFs.

Depending on the underlying bonds that the fund invests in, the types can be segregated as below:

#1 - Sovereign or Government Bond ETF

Sovereign or Government Bond ETFs consist of bonds issued by the Government. These investments are rated high since the Government issues them, so the returns on these bonds are slightly lower. As rightly said, the higher the risk, the higher the returns. The interest rates on these securities are way too short, and the tenure of these securities is long.

Examples

• Mortgage Back Securities ETF - These ETFs are backed by a pool of real estate mortgage loans and allow banks to offer mortgages.
• US Treasury ETF - This type of ETF includes the Treasury bonds issued by the US Government, these bear the minimum risk, and hence the returns are also minimized.
• Treasury Inflation-Protected Securities ETF - As the name suggests, this ETF protects investors from an increase in inflation. The principal value of the fund increases or decreases in line with the CPI, which means if the inflation shoots, so will the fund's value.

#2 - Corporate Bond ETF

Corporate Bond Exchange Traded Funds consist of bonds issued by organizations whose proceeds are used for business operation or project refinancing, depending on the organization's requirement. Since private organizations issue these, the bonds are considered to be risky and hence fetch higher returns. They sometimes are listed as a different basket of corporate bonds under high yield bond ETFs. Compared to stocks, bonds are less risky because if the issuer becomes bankrupt, the dues pending for the bondholders are paid before the stockholders.

Examples

• Investment Grade ETF - Bonds with ratings AAA to BBB are referred to as Investment Grade bonds, which are considered high credit ratings. This means the risk of the issuer default is very low; hence, the return is a bit low compared to other Corporate Bond ETFs.
• Junk Bond ETF - As the name suggests, these are bonds issued by organizations with a weak credit rating and have a higher chance of defaulting. These ETFs have a variety of Junk Bonds and hence offer higher yields, not to mention the risk involved due to the issuer's credibility.

#3 - Broad Market Bond ETF

This is the most popular type of bond exchange-traded fund since it offers many bonds in one fund, including sovereign bonds to corporate bonds. Since these have various bonds, investing in such funds reduces the risk of completely losing out on the investment, making a pathway for a long-term investment option with returns at regular intervals.

Example

The Unconstrained Bond Exchange Traded Funds allow the fund manager to invest in bonds across geographies, markets, credit ratings, and currencies, allowing the fund to reap the maximum benefits. Since the fund manager has the freedom to invest in any bond they desire, they can look for the bonds with the best returns at the lowest possible cost. The Unconstrained Bond ETF can be more expensive than other Bond Exchange Traded Funds due to this freedom.

Most ETFs in this segment of the market pay out monthly interest to their investors. However, capital gains, if any are treated as capital gains and credited to the investor’s account at the end of each year.

For taxation, it is either accounted under income or capital gains. For a short-term bond ETF, short-term capital gain tax might be applicable based on the jurisdiction, type of stock, and the tax slab of the investor.

Let us understand the advantages from the perspective of investing in high yield bond ETFs through the discussion below.

• Allows investors with limited capital to invest in the bond market, which otherwise can turn out to be a costly affair.
• Limited risk as compared to stocks or mutual funds since the Bond ETFs invest in bonds, and in case of bankruptcy, the bondholders are paid before the stockholders.
• Alternative investment option for investors looking to invest in low-risk securities for long-term returns.
• The interest payment is paid monthly, and capital gains are delivered through an annual dividend.
• Even when a specific bond is underperforming, the investor can recover from the investment made in a basket of bonds through Bond ETFs.
• Bond Exchange Traded Funds are available globally.

Despite the advantages mentioned above and throughout sections of the article, there are a few factors that prove to be a hassle for investors. Let us understand the disadvantages of long and short-term bond ETFs through the explanation below.

• The risk of losing the principal amount is higher in investing in a bond ETF since the Bond Exchange Traded Funds that have no maturity do not guarantee that the total principal amount will be repaid.
• The change in interest rates affects the price of the ETF, making it challenging to mitigate interest rate risk.
• Investing in a Bond Exchange Traded Fund requires sound knowledge about how bonds function. The investor needs to understand whether investing directly in a bond is a better option than investing in a Bond ETF.
• Since it carries a low risk, the returns are minimized compared to the potential returns earned by investing in stocks.

Investors with large amounts to invest put their money towards bonds which have a significant size of investment. For other investors, they tend to invest in bond ETFs, which are a basket of bonds of a specific type. Let us understand their differences through the comparison below.

Bond ETFs

• Bond ETFs are a basket of bonds, usually of a specific type such as treasury bonds or corporate bonds.
• They never reach a maturity date with the exception of reaching the ETF’s target maturity.
• They are more transparent and easily tradable than conventional bonds, which makes short-term bond ETFs an investors’ go-to option.
• They usually have more liquidity than the underlying asset itself.
• The interest from these investments is disbursed on a monthly basis.

Bonds

• Bonds are debt instruments with a fixed rate of interest and a maturity period issued by the government or large corporations to meet their financial requirements without giving up a share in their equity.
• The risk level decides the rate of return. For example, government bonds are almost risk-free and hence give comparatively low returns.
• They have a specific date of maturity.
• Bonds have poor transparency as a bunch of details are hidden from investors in fine print or are undisclosed altogether.
• They have poor liquidity. As in, it is difficult to find a buyer in the secondary market who would purchase a bond at its face value. They usually, get purchased at a discount.
• The interest payments are usually made twice a year.

This has been a guide to what is a Bond ETF. Here we explain its dividend aspect, types, advantages, and disadvantages, and compared it with bonds. You can learn more about financing from the following articles –

• Features of Agency Bond
• Dim Sum Bonds
• Compare - Mutual Funds vs ETFs
• ETF vs Index Funds