Investing in individual bonds can be complicated. Bonds don't trade in an open marketplace, they can be somewhat illiquid, and investors may need a broker-who will certainly charge for the service. Luckily, bond exchange-traded funds provide a potential alternative for small investors everywhere.
Investors may associate ETFs with stocks, thanks to the popular ETFs that track stock indices like the S&P 500. ETFs also happen to trade on stock exchanges, like the New York Stock Exchange.
Bond ETFs work similarly. Although the ETF holds bonds and not stocks, it trades on a stock exchange. Said another way, a bond ETF is a bundle of bonds that an investor can trade like a stock. Bond ETFs make it possible for investors to buy a diversified set of bonds without the big bucks it would take to build a portfolio of individual bonds.
What is a bond ETF and how does a bond ETF work? Find the answers to these questions below, along with the benefits to using bond ETFs when building out a balanced portfolio.
Before getting into the specifics of bond ETFs, it will be helpful to understand ETFs and bonds separately. Let's begin with ETFs.
Related: ETF trading: What to know about exchange-traded funds
What Is an ETF?
A fund provides a way to pool money with other investors so that money can then be spread across many different investments (sometimes referred to as a "basket" of investments).
For most small investors, it would be too costly to individually purchase 500 individual stocks or 1,000 individual bonds. But such a thing becomes possible when doing it alongside thousands of other investors. Funds provide investors with an incredible opportunity to diversify their investments.
For retail investors, investment funds come in two major varieties: mutual funds and exchange-traded funds. Mutual funds and ETFs are constructed differently. ETFs were built to trade on an exchange, as the name implies-but both can be useful tools in gaining broad diversification.
Whether investors will choose a mutual fund or ETF will likely depend on their preference and context. For example, someone using a workplace retirement plan may only have access to mutual funds, so that's what they use.
Someone who is using a trading platform may choose ETFs because it is possible to purchase them without any of the normally associated trading costs. Whether an investor is using a mutual fund or an ETF, what's most important is what's held inside that fund. Think of an ETF as a basket that holds some other type of securities, like stocks or bonds.
Most ETFs will hold just one type of security - only bonds, for example. A bond ETF could be broad, or it could contain a narrower sliver of the bond market, like corporate bonds or short-term treasury bonds.
What Is a Bond?
A bond is an investment in the debt of a company, government, or other entity. Investors loan the entity their money and then the entity pays interest on the amount of that loan.
Although an individual is not a bank, it may be helpful for investors to think of themselves as a miniature bank. Just as a bank collects interest on a mortgage loan, an investor collects interest on debt investments.
These IOUs are packaged into contracts called bonds. The terms are laid out in this contract. When investors buy a bond, they are agreeing to the rate of interest and other terms set by the bond. Because bonds pay a set rate of interest, bonds are sometimes referred to as fixed-income investments.
Bonds typically make interest payments, sometimes referred to as coupon payments, twice annually.
Let's say an investor buys a Coca-Cola bond for $10,000 that pays a 4% rate of interest over 20 years. The bond earns $400 every year, earning the investor a total of $8,000 over the 20-year period. At the end of the period, the $10,000 principal investment is returned. As long as the investor holds the bond for the full 20 years, there should be no surprises.
Because bonds pay a fixed rate of return, their earnings potential is largely predictable. But there is limited upside on what can be earned on a bond. For this reason, bonds are considered to be a safer, less volatile complement to stock holdings, which have a higher potential for returns over time.
Types of Bonds
Bonds are issued by different entities and are often categorized by the issuer. There are four categories of bonds available to investors:
- Treasury bonds: Bonds issued by the U.S. government.
- Municipal bonds: Bonds issued by local governments or government agencies.
- Corporate bonds: Bonds issued by a public corporation.
- Mortgage and asset-backed bonds: Bonds that pass through the interest paid on a bundle of debts, such as a bundle of mortgages, student loans, car loans, or other financial assets.
As one could imagine, there are many subtypes within these broad categories.
When it comes to risk, the bond market produces a wide range. Corporate, municipal, and asset-backed bonds are generally considered to be higher risk than treasury bonds. Whereas a business or even a municipal government could potentially "default" on a loan, it is highly unlikely that the U.S. government would go bankrupt. To date, the U.S. government has never defaulted on a treasury bond.
Because they are considered low risk, treasury bonds typically pay less interest than the other bond types. This is an important trade-off to understand. Higher-risk investments should pay a higher rate of interest in order to compensate the investor for taking on that additional risk.
This is why it is possible to see bonds with high rates of interest issued by unstable governments or by highly speculative companies. These are often referred to simply as high-yield bonds or junk bonds.
Bonds can also vary by their maturity dates. It is possible to purchase bonds with a wide range of timelines, ranging from the very short (a few days) to the very long (30 years). Although it depends on the current state of interest rates, long-term bonds tend to pay more than short-term bonds. This should make intuitive sense; investors want to be compensated for locking their money up for longer periods.
Benefits of Bond ETFs
Combine the two ideas, and voila: A bond ETF is born. How does a bond ETF work in practice? To understand, it is helpful to analyze the benefits of using bond ETFs.
They can be purchased in small dollar amounts
For some bonds, the starting price is $1,000. This can be prohibitive for small investors who don't have $1,000 to start building their bond portfolio, let alone a diversified one.
Generally, ETFs are sold by the share, and the cost of one share varies by ETF. Some trading platforms allow for the purchase of partial shares, which allows investors to get started with as little as $1.
They provide diversification
It is possible to buy into a fund of hundreds or thousands of bonds using a bond ETF. This type of diversification would be otherwise impossible to achieve for small investors trying to build a bond portfolio on their own. ETFs make diversification a possibility, even at very small dollar amounts.
They are low cost
ETFs, by their nature, are low cost. Because they are typically index by style, the management fee embedded within the fund. called the expense ratio, is typically quite low. Compare this to an actively managed mutual fund of bonds, where the expense ratios can top 1%.
There's another fee that investors will want to be aware of, called a trading cost or transaction fee. This is the cost of buying and selling ETFs (and stocks). These fees can be quite prohibitive for smaller investors. Luckily, there are ways to buy ETFs without paying any trading or transaction fees.
They are easy to buy and sell
Individual bonds are not always easy to buy and sell. Said another way, they are not particularly liquid. Bonds do not trade on an open exchange, like stocks and ETFs. It is likely that an investor would need to involve a professional to broker the transaction.
ETFs, on the other hand, are very easy to sell. Most banks and trading platforms allow investors to do it themselves, online. This way, an investment can be sold quickly if needed.
Downsides of Bond ETFs
Bond ETFs do have their downsides, though. Bond ETFs reveal underlying price changes in the bonds, which some investors may find disconcerting because yes, it is possible for bonds, and a bond ETF, to lose value.
When holding an individual bond or a portfolio of bonds, an investor is not provided minute-by-minute updates of the market value of that investment. In this way, a bond is like a house. There is no ticker sitting above anyone's house that tells them the value of that property at that very second.
This is not the case with a bond ETF, where price changes can be felt in near real-time. It will be important that investors are prepared for this. It is generally not wise to make a decision about long-term investments based on recent price gyrations, not just with stocks but with bonds, too.
Buying Bond ETFs
The first step is to research bond ETFs, as there are many kinds. Bond ETFs can be broad and cover a wide sample of the bond market, or they can be narrower. For example, it is possible to buy a long-term treasury bond ETF or a bond ETF that only holds certain municipal bonds.
Investors may want to spend time examining their goals and then choose the appropriate bond funds to match.
Once that decision is made, bond ETFs can be purchased at a brokerage firm of a person's choosing.
Pro tip: Search for a trading platform that doesn't charge trading or transaction fees.
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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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