Bond ETFs Vs. Bonds: Which Are Better?

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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