Bond ETFs Vs. Bonds: Which Are Better?

Bonds are great. They offer safe, steady and predictable returns that have low correlations to stocks, making them an excellent way to balance higher-risk equities in a portfolio. But for the average investor, investing in individual bonds is next to impossible.

The Downsides Of Buying Bonds

Investing in single bonds is difficult for many investors, due to:

  • Poor market transparency. Bonds trade over-the-counter (OTC), meaning there's no single exchange on which they trade and no official agreed-upon price. The market is difficult to navigate, and investors may find they receive widely different prices from different brokers for the same bond.
  • High markups. Broker markups on bond prices can be substantial, especially for smaller investors; one U.S. government study found that markups on municipal bonds can soar as high as 2.5%. Between these markups, bid/ask spreads and the price of the bonds themselves, the cost to invest in individual bonds can add up—fast.
  • Poor liquidity. Bonds vary widely in their liquidity. Some bonds trade daily, while others only trade weekly, or even monthly—and that's when markets work perfectly. In times of market distress, some bonds may stop trading altogether.

What Are Bond ETFs?

A bond ETF is a bond investment in a stocklike wrapper. A bond ETF tracks an index of bonds and tries to replicate its returns. Though these instruments hold bonds and only bonds, they trade on an exchange like stocks, giving them some attractive equitylike properties.

The Differences Between Bonds And Bond ETFs

Bonds and bond ETFs may comprise the same basic investments, but exchange-trading changes the behavior of bond ETFs in several important ways:

  • Bond ETFs do not mature. Individual bonds have a fixed, unchanging date at which they mature and investors get their money back; each day invested is one day closer to that result. Bond ETFs, however, maintain a constant maturity, which is the weighted average of the maturities of all the bonds in its portfolio. At any given time, some of these bonds may be expiring or exiting the age range that a bond ETF is targeting (e.g., a one- to three-year Treasury Bond ETF kicks out all bonds with less than 12 months to maturity). As a result, additional bonds are continually being bought and sold to keep the portfolio's maturity constant.
  • Bond ETFs are liquid even in illiquid markets. The tradability of single bonds varies widely. Some issues trade daily, while others can trade as little as once a month. In times of stress, they may not trade at all. In contrast, bond ETFs trade on an exchange, meaning they can be bought and sold at any time during market hours, even if the underlying bonds themselves are not trading at the time.

    This has very real effects. For example, one source found that, on average, high-yield corporate bonds trade fewer than half the days each month; meanwhile, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) trades millions of shares each day.

  • Bond ETFs pay out monthly income. One of bonds' biggest benefits is that they pay out interest to investors on a regular schedule. Usually, these coupon payments happen every six months. But bond ETFs hold many different issues at once, and at any given time, some bonds in the portfolio may be paying their coupon. As a result, bond ETFs usually pay interest monthly, rather than semiannually; the value of this payment can vary from month to month.

Bond ETF Advantages

Bond ETFs offer many advantages over single bonds:

  • Diversification. With an ETF, you can own hundreds, even thousands, of bonds in an index at a purchase price significantly less than what it would be to invest in each issue individually. It's institutional-style diversification at retail prices.
  • Ease of trading. No more wading through the opaque OTC markets to haggle over prices. You can buy and sell bond ETFs from your regular brokerage account with the click of a button.
  • Liquidity: Bond ETFs can be bought and sold at any time during the trading day, even in overseas or smaller markets where individual issues might trade much less frequently.
  • Price transparency. With a bond ETF, there's no more uncertainty over what your investment is worth: ETF prices are published publicly on the exchange and updated every 15 seconds during the trading day.
  • More frequent income. Instead of coupon payments every six months, bond ETFs usually pay interest monthly. Though the value may vary from month to month, monthly payments give bond ETF investors a more regular income stream to use or reinvest.

Bond ETF Drawbacks

There are two main downsides to bond ETFs.

  • You aren't guaranteed to get your money back. Because bond ETFs never mature, they never offer the same protection for your initial investment the way that individual bonds can. In other words, you aren't guaranteed to get your money back at some point in the future.

    Recently, however, some ETF providers have begun issuing ETFs with specific maturity dates, which hold each bond until they expire and distribute the proceeds once all bonds have matured. Guggenheim, for example, offers 16 investment-grade and high-yield corporate bond target-maturity-date ETFs under its BulletShares brand, with maturities at different years (2017, 2018 and so on); iShares offers six target-maturity-date municipal ETFs. (Related: “I Heart BulletShares ETFs”)

  • You can lose money if interest rates rise. Interest rates change over time. When they do, the value of bonds may fall, and selling those bonds can lead to losing money on your initial investment. With individual bonds, you mitigate the risk by just holding on to a bond until maturity, when you'll be paid its full face value. Bond ETFs don't mature, however, so there's little you can do to avoid the sting of rising rates.

Which Are Better: Bonds Or Bond ETFs?

For most investors, buying individual bonds is out of the question. Even if it weren't, bond ETFs offer diversity, liquidity and price transparency that single bonds can't match, with the added benefits of intraday tradability and more frequent income payments. Bond ETFs do carry some additional risks, but all in all, they're probably a better and more accessible option for the average investor.

Next: Are Bond ETFs More Liquid Than Bonds?

Other Articles Of Interest
Leveraged And Inverse ETFs: Why 2x Is Not The 2x You Think
Leveraged And Inverse ETFs: Understanding Monthly Resets

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