Bond ETFs Explained
Fixed income securities are a mainstay of investor portfolios. While they come in many shapes and sizes, bonds and other fixed income securities are simple in principle—they’re loans from the investing public to an institution that needs money.
Issuers of the bonds are the borrowers, and investors are the lenders. Investors who lend the money expect to be repaid, and they expect to be compensated for the use of their money and the risk they take in making the loan.
Investors’ compensation—the interest on the loan—often takes the form of a regularly paid coupon, say, 5% per year. It’s this coupon payment—a consistent, repeating cash flow—that gives fixed income its name.
The fact that bonds provide a steady cash return and eventually repay all of the original capital (assuming all goes well) gives them a unique role in a portfolio—they provide a steady flow of returns with lower volatility than equity.
However, for years, bonds have been used as a counterbalance to equity investments for another reason: Historically, when stocks go down, bonds often go up, though we’ve seen more of a disconnect in recent years.
But why do bonds “go” anywhere? Don’t they pay regular coupons, as well as return the principal?
In fact, the value of the bond changes over time. Imagine a hypothetical bond’s 5% coupon perfectly compensates the investor at the time of issue. The investor receives $5 per year for the $100 initially lent.
But if inflation shoots up unexpectedly by 2% the year after the bond is issued, the same company might issue nearly identical bonds with a 7% coupon. Suddenly, last year’s bonds with their 5% coupons don’t look very attractive to investors.
Since the coupon is fixed at 5%, the only thing that can reflect the bond’s disadvantage is its market price, which, in this example, will go down—let’s say to $98. The point here is that, while the coupon of the bond is fixed, the bond’s value on the market—and in your portfolio—is not.
The relationship of a bond’s coupon to its current market price is captured in its yield. In our example, the yield of the bond paying the 5% coupon at the time it was issued was also 5%. But when the bond’s market value went down from $100 to $98, the bond’s yield went up. Intuitively, we know that the $5 coupon is more than 5% of the new, lower $98 value.
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The math is a bit more complicated than this, but the idea is that the yield of the bond expresses the value of the coupon payments relative to the current market price of the bond. When the bond’s market price goes down, its yield goes up, and vice versa.
Fixed Income ETFs: The Basics
Like equity ETFs, fixed income ETFs offer exposure to a basket of securities that, in this case, is a basket of bonds. Fixed income ETFs target all corners of the market, from speculative emerging market debt to top-notch U.S. government debt.
There are trade-offs to investing in bonds versus bond ETFs, and the differences from equity ETFs have a lot to do with the fact that bonds don’t trade on exchanges, but over the counter. This means investors can run up against poor market transparency or poor liquidity. But the ETF wrapper means that you’re accessing a basket of bonds that can be traded like a stock.
One thing to consider is that, unless designed to do so, a bond ETF never matures, with bonds entering and leaving the portfolio as they are issued and mature. However, there are target-maturity bond ETFs on the market that invest in bonds maturing in the same year, simulating the behavior of an individual bond and allowing investors to use them for popular bond strategies like laddering.
Because bond ETFs trade on an exchange, they can be more liquid than investing in an individual bond. Bond markets are notoriously illiquid, but bond ETFs trade daily on stock exchanges and can (usually) avoid the illiquidity of bond markets. Additionally, because of their transparency, bond ETFs can contribute to price discovery in bond markets.
The process for picking a fixed income ETF is similar to picking any other asset class. First, you’ll need to determine your targeted exposure—the type of bonds you’re interested in. Next, you’ll need to consider the credit ratings and interest rate risk of the ETF’s underlying securities.
Very broadly speaking, fixed income ETFs fall into four categories:
Sovereign: ETFs targeting fixed income security issues by governments of sovereign nations, U.S. Treasurys and U.K. gilts
Corporate: ETFs targeting fixed income securities issued by corporations
Municipals: ETFs targeting fixed income securities issued by U.S. municipalities
Broad Market: ETFs that have exposure to both sovereign and corporate debt
You’ll also need to consider other criteria like geographic exposure and the construction and methodology of your bond ETF’s underlying index. And if it’s actively managed, you should understand the process its manager uses to select securities.