Bond ETFs come in many different flavors, but they generally fall into one of four categories: sovereign; corporate; municipal; and broad market.
With hundreds of bond ETFs on the market today, it can be hard to know how to decide which is best for you. To help you make your choice, we've broken down the most common bond ETFs below.
Types Of Bond ETFs
Most bond ETFs fall into one of four main categories:
- Sovereign: Tracks bonds issued by the governments of sovereign nations, including the U.S.
- Corporate: Tracks bonds issued by corporations
- Municipals: Tracks bonds issued by local U.S. municipalities
- Broad Market: Tracks some blend of the above
There are many further ways to slice and dice these four categories. Some ETFs further screen their securities by credit quality or maturity, while others narrow the field by geographical region or industry. So it's not enough to know what your ETF holds; you also have to know why, and in what weights.
Sovereign Bond ETFs
Sovereign bond ETFs track the debt issued by the governments of sovereign nations. Examples of sovereign bond ETFs include:
- U.S. Treasury ETFs
The U.S. Treasury issues several bonds, known as Treasurys, to raise the funds necessary to run the government. These include T-bills, Treasury notes and savings bonds. Though they don't earn much interest over time, Treasurys are some of the safest investments around.
Most U.S. Treasury ETFs feature a blend of Treasury types with a specific maturity or range of maturities. One of the largest Treasury ETFs is the $11 billion iShares 1-3 Year Treasury Bond ETF (SHY | A-97), which tracks Treasurys with maturities between one and three years.
- Treasury Inflation-Protected Securities (TIPS) ETFs
This special class of Treasury security is designed to protect investors from inflation. Its principal value scales with increases and decreases in the Consumer Price Index, such that if inflation rises, so too will the TIPS’ value.
The largest TIPS ETF is the $14 billion iShares TIPS Bond ETF (TIP | A-99), which tracks an index of TIPS with at least one year left until they mature.
- Mortgage-Backed Securities (MBSs) ETFs
Mortgage-backed securities are bonds backed by a pool of real estate loans; they allows banks more freedom in offering mortgages to homeowners or other real estate investors. Unlike conventional bonds, which make regular interest payments then return your principal upon maturity, MBSs will return some portion of your principal with each interest payment.
At $7.2 billion in assets under management, the iShares MBS ETF (MBB | A-99) is the largest MBS ETF available.
- International Bond ETFs
There are as many ways to slice and dice the foreign market as there are markets. International bond ETFs may cover single countries or entire regions, from developed markets to emerging economies, and they may offer any size yield, duration or maturity.
One of the largest international bond ETFs is the $5.3 billion iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB | B-58), which tracks U.S. dollar-denominated debt issued in emerging markets.
Corporate Bond ETFs
Corporate bond ETFs hold the bonds issued by companies to raise capital and finance their operations. They offer higher returns than many kinds of sovereign bond ETFs, including Treasurys, which have had rock-bottom interest rates for years. They're also safer than a stock play: In case of bankruptcy, a company will pay off its bonds first, even before its commitments to stockholders. Still, corporate bond ETFs can carry a higher risk of default than other types of bond ETFs.
Some of the different flavors of corporate bond ETFs include:
- "Investment grade" ETFs
These ETFs include corporate bonds with higher credit ratings, and therefore a low risk of default. In the Standard & Poor's rating system, which is the gold standard of bond ratings, investment-grade bonds range from AAA to BBB.
The largest investment-grade corporate bond ETF is the $21.5 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77).
- "Junk bond" ETFs
These ETFs include corporate bonds with lower credit ratings. Generally they offer higher yields—but they also carry higher risk. In the Standard & Poor's rating system, anything below BBB is a junk bond.
By assets, the most popular junk bond ETF is the $14 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68).
- Hybrid security ETFs
These ETFs focus on securities that combine characteristics of stocks and bonds, such as preferred stock and convertible bonds. Preferred stock is a type of equity that also pays fixed dividends to investors, while convertible bonds can be converted into stock at a specific strike price. Hybrid ETFs allow investors to partake of corporate growth (albeit not as much as a straight-up equity investment) while still being protected from downside risk.
The $13.5 billion iShares U.S. Preferred Stock ETF (PFF | B) is the largest of several preferred stock ETFs on the market, while the $2.9 billion SPDR Barclays Convertible Securities ETF (CWB | C) is the only convertible bond ETF currently available.
- Senior bank loan ETFs
Senior bank loan ETFs track a specific kind of debt issued by banks that, legally, is considered the highest-priority loan possible. In case of bankruptcy, these loans must be repaid before anything else.
- The $5.4 billion PowerShares Senior Loan ETF (BKLN | C) is the most popular senior bank loan ETF in the space.
Municipal Bond ETFs
Technically, municipal bonds, or "munis," are a type of sovereign bond. They're debt issued by a state, county, city or even a town within the U.S. in order to finance such projects as highways or schools. Most muni interest payments are exempt from federal taxes, and often state and local taxes. They also tend to be very safe investments, with an average of 0.03 percent defaults over the past five years, according to research from Moody's.
Municipal bonds can be illiquid and expensive to purchase, even for bonds, meaning ETFs can offer substantial benefits to investors. Municipal bond ETFs can be bought and sold at any time during the trading day, for lower cost and with greater diversification than if you bought each bond piecemeal.
The most popular municipal bond ETF on the market right now is the $5.1 billion iShares National AMT-Free Muni Bond ETF (MUB | B-79).
Broad-Market Bond ETFs
The most popular bond ETFs available are still the one-stop-shop total-market blends, which package sovereign, corporate and municipal debt together. Broad-market bond ETFs often act as core fixed-income exposure for many investors.
Other Types of Bond ETFs
As the bond ETF market matures, issuers have gotten more creative in their product offerings. Some of the more sophisticated flavors of bond ETFs include:
- Money Market Alternatives
Instead of parking cash in a money market, investors can access the same flexibility in short-duration and ultra-short-duration fixed-income ETFs. Plus, in a low-rate environment, these funds often offer much higher yields.
- Leveraged/Inverse ETFs
Leveraged bond ETFs are designed to provide a multiple—either positive or negative—on the daily returns of their indexes. In the same vein, inverse bond ETFs provide the inverse of the daily return of their indexes. This is not the same as the multiple, or the inverse, of an index's long-term return. Over long periods of time, the difference between your naive expectation and the final return can be significant. Do your homework before buying.
- Unconstrained/Tactical Bond ETFs
Unconstrained or tactical bond ETFs are actively managed funds that give free rein to their portfolio managers to pull bonds from any market segment, regardless of issuer, credit rating, sector or geography. The idea is that greater manager freedom may allow managers to seek out the most profitable corners of the market; it often also makes these products more expensive.
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