A bond exchange-traded fund (ETF) is a fund that invests in commercial, municipal, and government bonds. Investing in these ETFs is a good way to have a diversified portfolio that is made up of tens and often hundreds of bonds. In this report, we will look at the complete process of investing in bond ETFs.
What is a bond ETF?
To understand what a bond ETF is, we need to look at what a bond is and what an ETF is. A bond is a type of loan that investors lend to a company or government. The bond assures an investor consistent returns over a long period.
Governments and companies are always in need of money to pay their employees and invest in fixed assets. In this case, borrowing from banks is usually not ideal because of the high interest rates they charge. For companies, offering more equity is also not ideal since it involves diluting existing shareholders.
Therefore, through bonds, governments, municipals, private and public companies go to the market and issue bonds.
On the other hand, an ETF is a fund that is listed in either the New York Stock Exchange (NYSE) and Nasdaq. The fund is made up of many bonds. There are two main types of these ETFs. A passive ETF tracks a certain index. This means that its composition is usually relatively constant. Second, there are active ETFs, whose composition is regularly changed by the fund manager.
Types of bonds
To invest in bond ETFs, you need to understand the various types of these funds:
Corporate bond ETFs
These are ETFs that track bonds issued by corporations. A good example of this is if companies like Amazon and Microsoft raises money from the market.
These bonds are classified into:
- Investment grade bonds – These are bonds issued by companies with high credit ratings. For example, a firm like Johnson & Johnson that has a triple A rating is in this category. These bond ETFs are usually ideal for people who want consistent return for a long term. The iShares iBoxx investment grade ETF, which has more than $55 billion in assets, is the biggest in this category.
- Junk bonds ETF – These ETFs are made up of high-risk firms that have low credit scores. These bonds tend to have a higher yield but higher risks. The iShares iBoxx high yield ETF is the biggest in this category with its holdings worth more than $25 billion.
- Hybrid bond ETFs – These ETFs are made up of a combination of investment grade and junk bonds ETFs.
- Senior bank loan ETFs – These are ETFs made up of loans issued by banks.
Sovereign bond ETFs
These are bond ETFs that are made up of bonds that are issued by the government. For example, the US government is the biggest issuer of these bonds. Its $26 trillion national debt is made up mostly of these bonds.
The main types of sovereign bonds are:
- US treasury issued bonds – These are bonds that the Treasury Department issues. For example, when congress passed its stimulus packages, the Treasury Department raised these funds through bonds.
- TIPS – Tips track the Treasury Inflation-Protected Securities. In other words, these bonds are usually adjusted for inflation.
- Internationals – These are ETFs that track bonds issued by several countries.
- Mortgage backed securities (MBS) – These bond ETFs track a collection of securities that are backed by mortgages.
Municipal bond ETFs
Commonly known as munis, these bond ETFs track bonds that are issued by municipalities. Examples are the Invesco taxable municipal bond ETF that has more than $2 billion in assets.
Leveraged bond ETFs
These are relatively high-risk bonds that use borrowings to increase investors’ returns. Examples of these bond funds are UltraShort Barclays 20+ Year Treasury and Direxion Daily 20-Year Treasury Bear 3X.
Sample bond ETFs
Key terminologies in bond ETF investing
To invest in bond ETFs, you need to understand some of the most important terminologies. These terms will determine the cost and the overall returns that you can have.
- Expense ratio – This is an important term that refers to the annual fees that the fund manager will charge you. For example, the Vanguard Total International Bond ETF has an expense ratio of 0.09%. As such, you will pay 0.09% for every $1,000 of your investment.
- ETF yield – A yield refers to the total amount of money that a fund pays to investors as a percentage of the Net Asset Value (NAV). Bonds of highly-rated firms or governments tend to have lower yields. For example, the SPDR Bloomberg Barclays High Yield Bond has a yield of ~5.5% while the Vanguard Total Bond Market ETF (BND) has a yield of ~2.38%.
- Dividend frequency – This refers to the period which the ETF pays dividends. It could range from monthly, quarterly, semi-annually, and annually.
- Number of holdings – As the name suggests, it refers to the number of holdings that a fund has. For example, the BND has more than 18,000 holdings.
- Credit rating – A credit rating is an important number that measures the ability for a company or country to pay its debt. The ratings are usually provided by agencies like Moody’s, S&P Global, and Fitch.
How to invest in bond ETFs
If you have invested in stocks before, allocating funds in bond ETFs will be relatively easy. That is because these funds are listed in the major exchanges like the New York Stock Exchange (NYSE) and Nasdaq. As a result, they are offered by all major brokerage firms, including Robinhood, Charles Schwab, and TD Ameritrade.
Next, you need to have a long-term horizon when investing in bond ETFs. That is because the prices of bond ETFs tend to move relatively slowly, which is not ideal for traders.
We also recommend holding different categories of bond ETFs. For example, your portfolio could have high-yield ETFs, Treasury Inflation-Protected Securities, and even mortgage-backed securities. Still, always ensure that you look at the expense ratio and the historical dividend yield.
The easiest way to conduct your research about these ETFs is to use one of the several free analysis tools like Seeking Alpha and ETFdb.
Bond ETFs are an excellent way to diversify your portfolio and offer consistent returns over the years. They are also extremely liquid, meaning that you can buy one and exit the following day. Most importantly, bond ETFs are less risky than investing in individual bonds and stocks. Therefore, we recommend that you have at least two or three funds in your long-term portfolio.