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.