If you are looking for income, diversification, and exposure to a specific asset class, bonds can play an important role in your investment portfolio. When looking at the bond universe, bond mutual funds, bond exchange-traded funds (ETFs), and a diversified portfolio of individual bonds offer ways to obtain the benefits of fixed income.
Here are a few key things to know about bond ETFs—and some ETFs to consider.
The big bond world
When it comes to the bond market, you have a lot of choices. It can be a daunting task to assemble and maintain an appropriately diversified portfolio of individual bonds, given the size and diversity of the well over $150 trillion bond universe.1
Buying bonds in the past was more complicated, as the bond market used to be more opaque and fragmented. Today, with visibility into recent trades, depth of available inventory, and access to most of the available secondary market offerings, you are able to get a better snapshot of a bond’s value and its liquidity than ever before.
In addition, bond mutual funds and bond ETFs are often a low-cost way to buy a diversified basket of bonds, even if you have a relatively small amount of money to invest. For a detailed comparison of the features of bonds, bond mutual funds, and bond ETFs, see the table.
Bond funds vs. bond ETFs vs. bonds
| Income potential | Growth potential | Principal preservation | Fees or expense ratios | Investment and diversification | |
|---|---|---|---|---|---|
| Bond mutual funds | Regular fund distributions, though amounts vary depending on the underlying bond holdings of the fund. | Potential for capital appreciation and loss. | Most bond funds do not have a maturity date, so principal will fluctuate. Most funds can be bought and sold daily. | Mutual funds charge a fee represented by the expense ratio, which reflects operating expenses as a percentage of the fund’s average net asset, as well as any transaction or load fees. | Bond funds are portfolios of bonds, which can offer broad diversification, depending on the fund’s investment objective. |
| Bond ETFs | Regular fund distributions, though amounts vary depending on the underlying holdings of the fund. | Potential for capital appreciation and loss. | ETFs can be bought and sold intraday on an exchange. Most ETFs do not have a maturity date, so principal will fluctuate. | Net expense ratios tend to be lower than bond mutual funds but can be comparable to some, and trading fees depend on product and platform. ETFs may trade at a premium or discount to net asset value (NAV), and are subject to a bid/ask spread. | No minimum investment required. Bond ETFs are portfolios of bonds, which can offer broad diversification, depending on the fund’s investment objective. Some are narrowly focused. |
| Individual bonds | Fixed-rate bonds offer periodic payments of fixed amounts. Other types of bonds may vary payments. | None if bought at par value and held to maturity without default. Bonds can be purchased and sold in the secondary market prior to maturity at a profit or loss. | Principal or par value of the bond returned at maturity, subject to the creditworthiness of the issuer. Secondary market sale can result in a profit or loss and day-to-day values will fluctuate. | Brokerage fees may apply. No fee or charge for new-issue bonds, Treasuries, CDs, and munis. If not held to maturity, transaction cost (bid/ask) will be impacted by position size. There are costs for transacting in the secondary market. | The minimum is generally $1,000 to $5,000, depending on the type of bond. To be diversified, you will need to buy a basket of bonds. |
Bond funds up close
While bond mutual funds have been around longer, bond ETFs are growing in popularity. Since the first US-listed bond ETF was launched in 2002, bond ETFs have accumulated over $2.4 trillion in assets.2
Bond ETFs are similar to bond mutual funds in that both hold a basket of individual bonds and can be passively managed (the fund attempts to mirror the performance of a bond index or benchmark) or actively managed (the fund attempts to outperform a bond index or benchmark).
Both bond mutual funds and bond ETFs can provide exposure to a variety of markets, sectors, maturities, and credit qualities.
Their tax treatment is similar too, although ETFs can have a tax advantage when it comes to capital gains as they are able to minimize capital gains distributions through the creation and redemption mechanism. When it comes to individual bonds, you generally pay income taxes on interest received at ordinary income rates, unless the bond is tax-exempt, but you don’t pay capital gains taxes unless you sell the bond before maturity at a profit. With a bond ETF or Fund, you will likely be required to pay income taxes on interest received, typically through a monthly dividend (e.g., a fund distribution), at ordinary income tax rates, unless the ETF or Fund is focused on investing in municipal bonds. Furthermore, you may need to pay capital gains taxes on any capital gain accumulated at the time of sale and any capital gains paid out by the fund over your holding period, typically through an annual dividend (e.g., a fund distribution).
However, there are some differences. Whereas a bond mutual fund’s price is set at the end-of-day market price, a bond ETF is bought or sold at the intraday market price, which may be different than the ETF's net asset value (NAV).3
Bond mutual funds generally provide holdings disclosures monthly and discourage short-term trading of fund shares. In comparison, the vast majority of bond ETFs are required to disclose their holdings daily to support daily exchange trading activity. Depending on distribution models and to control short-term trading, bond mutual funds may be subject to redemption or transaction fees; bond ETFs are not. Instead, bond ETFs are subject to bid-ask spreads and brokerage commissions or fees.
“Bond ETFs might be most appropriate for those fixed income investors who like the advantages of ETFs, including intraday trading and holdings transparency,” explains Montanna Saltsman, ETF strategist with Fidelity. “Bond ETFs let you tactically pick and choose when you want to enter and exit the market, based on prevailing market conditions.”
Bond ETF risks
Of course, just as bond ETFs provide certain advantages, they also have risks. Bond ETFs have risks similar to individual bonds and bond mutual funds, such as maturity, interest rate, and credit risk. Bond ETFs also have tracking risk (a measure of risk that is due to active management decisions made by the portfolio manager), and their potential valuation may be at a premium or discount to NAV. It is worth nothing that passively managed bond funds can also exhibit tracking risk.
Additionally, some bond ETFs may not have a long enough track record to analyze how they might react to different market conditions and phases of the business cycle.
Abundance of bond ETF opportunities
You should decide for yourself whether bond ETFs, bond mutual funds, or individual bonds are right for you. Or a combination of these different types of products might be suitable, depending on your specific investing objectives, risk constraints, and time horizon. Whatever route you choose, a strong case for active bond management can be made in today's market, given the size and complexity of the bond universe.