What bond ETFs are how they work and what to look for when selecting them

Post on: 5 Май, 2015 No Comment

Key Points

Bond investors have historically held individual bonds issued by corporations, governments or other entities. While individual bonds generally feature a set stream of interest payments and a set value at maturity (assuming they don’t default), they can be expensive to trade and it can be difficult to achieve adequate diversification—for example, with corporate bonds, you’ll want to invest in at least 10 different issuers.

Many investors looking for an easier way to build a diversified bond portfolio have turned to bond exchange-traded funds (ETFs)—which offer exposure to entire segments of the market, such as investment-grade corporate bonds—in a single investment. Additionally, they come with low expenses and the ability to trade intraday. Before buying bond ETFs, continue reading to learn what they are, how they work, and what you should look for when picking one of these funds.

Understanding a bond ETF’s value

The value of a bond ETF will rise and fall with the value of the underlying bonds. This fluctuating value can confuse many first-time bond ETF investors. With an individual bond, if you buy it at its face value of $1,000, you expect to get that $1,000 back when it matures, plus the interest you collect along the way. However, if you were to sell that bond prior to maturity, you might not get $1,000 for it. Depending on the interest rate environment and the time to maturity, you could get more or less than the bond’s face value.

A bond ETF will reflect these price differences in its daily value. If interest rates in the market go up, the values of the bonds in the portfolio may go down (depending on whether the rates of the bonds in the portfolio are lower than the prevailing market rates). As a result, the ETF’s price may fall. If the market feels more confident about the economy and is willing to buy riskier bonds, the value of a bond ETF that holds riskier bonds will rise.

Selecting the right market exposure

The most important thing to consider before buying a bond ETF is the index that the ETF aims to track. Some bond ETFs track very broad indexes of investment-grade bonds, such as the Barclays U.S. Aggregate Bond Index. This index is made up of thousands of bonds backed by the U.S. Treasury, government agencies, pools of mortgages and highly-rated corporations.

Other bond ETFs track narrower indexes, such a single slice of the Barclays Aggregate or a narrow range of maturity such as one to three years or 20-plus years. There are also ETFs that focus on foreign bonds, corporate bonds, municipal bonds or high-yield bonds (that is, riskier corporate bonds). The benefits and risks—which tend to be greater in these narrow categories—will vary depending upon the type of index the bond ETF tracks.

Knowing the risks

Bond ETFs are subject to the two most basic risks involved with bonds: credit risk and interest rate risk.

Credit risk. also known as default risk, is the risk that a bond issuer will not pay the interest and principal that it owes to bondholders. If the issuer defaults, it’s possible bondholders could get nothing at all. Even if the issuer doesn’t default, the bond’s market value could still go down if the market begins to fear a future default, which would depress the price of ETFs that hold that bond. High-quality bonds like U.S. Treasuries might have little to no credit risk, while high-yield bonds from low-rated companies (sometimes called junk bonds) would have a great deal of credit risk.

Interest rate risk. also known as duration risk, is the risk that a bond might lose value if interest rates in the market rise. If you own a bond with 10 years until maturity that’s paying 4% interest, but new 10-year bonds from the same issuer are coming out with 6% interest, no one would be willing to pay full price for your 4% bond if you tried to sell it today. The longer a bond has until maturity, the more sensitive its value is to changes in market interest rates. Bonds with only a few months until maturity have very little interest rate risk.

ETFs also have their own unique set of risks to be aware of:

Wide bid-ask spread: Because ETFs trade intraday at a price that’s determined by the supply and demand in the market, there’s the risk of having a wide spread between the price at which market makers are willing to sell an ETF (the ask price) and the price at which they’re willing to buy it (the bid price). If the ETF doesn’t trade many shares each day, the bid-ask spread could be quite wide, which could add up to a meaningful expense if you trade frequently. Look for ETFs whose bid-ask spreads are less than a quarter of a percent of the ETF’s price (usually a few cents per share).

Price straying from NAV: An ETF’s price could stray from its net asset value (NAV)—the total value of all securities in the portfolio divided by the number of shares outstanding—particularly when the underlying investments are hard to trade, as is the case with some high-yield and international bonds. In the past, some bond ETFs have traded at prices above their NAV for long periods as investors consistently added money to these ETFs while the underlying bonds were somewhat expensive to trade. If investor flows had reversed, these funds could have traded at prices below their NAVs for extended periods. If you buy ETF shares when the price is above NAV and sell when the price is below NAV, the difference is effectively an added transaction cost.

Tracking error: ETFs are designed to mimic an index, so you might expect that the ETF manager would simply buy all of the bonds in the index in the same proportions that they appear in the index. And with some ETFs, such as those that track large-cap U.S. stock indexes, the ETF manager may do exactly that.

However, most bond indexes have so many thousands of bonds with different maturity dates and interest rates from different issuers that it can be impossible for an ETF manager to buy all of them. In these cases, the manager will sample and optimize the portfolio—that is, buy a representative sample of bonds whose overall characteristics match the index closely. This can result in a portfolio of 50 or 100 relatively liquid bonds rather than the thousands of illiquid bonds in the index.

When done properly, the returns on the ETF can still match the index very closely. However, it’s possible that the ETF’s portfolio may differ widely, causing the ETF’s performance to be higher or lower than that of the index. This is called tracking error, and it should be minimized. Look for ETFs whose returns match their benchmark indexes closely and from companies with well-established track records of managing index funds.

Choosing a bond ETF

If you’re comfortable with credit risk because you believe that the economy will do well and that companies are likely to have higher earnings and be able to pay their bondholders more easily, you may want to look for a corporate bond ETF or high-yield bond ETF to take advantage of the higher yields that tend to come with more credit risk. If you worry about credit risk, consider a government or Treasury bond ETF.

If you think that interest rates are likely to rise, you might prefer an ETF that focuses on bonds with very short maturities. If you feel that rates will be stable or falling, you might like longer-maturity bond ETFs that may pay a higher interest rate.