Exchange traded funds are popular with investors because of their low costs and reliable returns—not to mention the fact they’re an affordable way for new investors to diversify their portfolios. A fixed income ETF is a specific type of ETF that may be especially useful if you’re interested in purchasing government bonds—whether you’re a new or seasoned investor.
How does a fixed income ETF work? And what are some of the best fixed income ETFs to invest in?
What are Fixed Income ETFs?
A fixed income ETF (also known as a “bond ETF”) is an exchange traded fund that only invests in bonds. While a regular ETF holds a collection of stocks or commodities, a bond ETF only holds a collection of bonds. A bond ETF may hold hundreds or even thousands of different bonds.
Most bond ETFs will include a specific subset of bonds. Here are some of the most common areas of focus:
Government bonds: These bond ETFs contain bonds that are issued by either the federal government or by local governments (municipal bonds). U.S. Treasury bonds are often considered the most lucrative type of government bond.
Corporate bonds: Some bond ETFs will only contain corporate bonds that have been issued by large companies.
International bonds: These bond ETFs will contain bonds that are issued by foreign governments.
Maturity: Some bond ETFs contain only short-term bonds, while others include only long-term bonds.
So why’s it called a “fixed income ETF” anyway?
“Fixed income” refers to any security that gives investors a fixed amount of interest or dividends until maturity is reached—namely, bonds.
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How Do Bond ETFs Work?
Bond ETFs are passively managed, which means that there’s no financial manager who’s picking which bonds will be brought into the fund. That means that the costs associated with bond EFTs are very low, much lower than mutual funds (which are actively managed).
If there’s no financial manager, then how are fixed income ETFs created?
Bond ETFs are created in the same way that other types of ETFs are created. A fund provider (often a brokerage firm) purchases all of the bonds that will be included in the bond ETF. The bonds are owned by the fund provider, but investors can buy shares of the ETF on the stock market.
When you purchase shares of a bond ETF you’ll essentially become a shareholder. Just like if you were a shareholder in a corporation, you’ll receive monthly dividends, interest payments, and capital gains (if any of the bonds in the fund are sold for a profit).
Unlike individual bonds, bond ETFs have no maturity date. The bonds within the ETF will mature, but the proceeds are simply reinvested in new bonds. You won’t get back your principal unless you sell your shares. If you do decide to sell your shares, you may receive more or less than what you paid for them depending upon the market conditions (that’s why they’re optimal for active traders—you can potentially buy at a low price and sell at a higher price).
Bond ETFs are ideal for investors because they’re traded throughout the day on a centralized exchange. The price of the bond ETF will change throughout the day as investors buy and sell shares. In other words, a bond ETF has high “liquidity.”
Individual bonds are not traded in the same way. If you wanted to purchase an individual bond, you would have to purchase through a bond broker. It’s a more rigid process than investing in a bond ETF and usually comes with higher trading fees. Furthermore, an individual bond typically costs more money upfront and so it’s a difficult investment for beginning investors who have less capital to work with.
Pros of Bond ETFs
Let’s identify the main advantages of fixed income ETFs:
Diversification (Less Risk)
Low Expense Ratios
1. Diversification (Less Risk)
A bond ETF is a fantastic way to diversify your investment portfolio, especially if you’re a new investor. Most investors strive to buy into a variety of different investments, from stocks, to bonds, to real estate. If one investment fails to produce the expected returns, the investor can count on the other investments to keep up the cash flow.
Bond ETFs are advantageous because they’ll give you a steady, reliable return—your earnings won’t be affected by the company’s profits or by what’s happening in the market. If you have investments that are a little riskier, it’s a good idea to balance them out with a bond ETF that can produce surefire profits.
ETFs are easy to purchase, so you’re able to diversify your selection of bond ETFs with little difficulty. For instance, you could purchase shares in both a short-term bond ETF and a long-term bond ETF, or a government bond ETF and a corporate bond ETF. When you have shares in multiple types of bond ETFs, you’ll have a less volatile investment portfolio overall.
A robo-advisor (an online feature that’s often available with online brokers) will automatically select bond ETFs that meet all of your investment interests.
Bond ETFs are traded on the stock market so they’re far more liquid than individual bonds. Individual bonds aren’t traded on the stock market—they’re traded through bond brokers. Therefore, it’s unclear just how many buyers and sellers there are, which can make it difficult to buy or sell at a moment’s notice. The lack of liquidity also results in higher bid-ask spreads (basically a trading fee). All in all, it’s more difficult for individual investors to purchase individual bonds.
But since a bond ETF trades on the stock market, there’s a lot more transparency about who’s buying, who’s selling, and what the prices are going to be. It’s also easier for you to seize upon those desirable ETFs that drop in price during the trading day.
3. Low Expense Ratios
So long as you purchase bond ETFs that are passively managed, your expense ratios are likely to be low. You won’t have to deal with the management funds that are included with actively managed ETFs or mutual funds. And your expense ratio might even be lower if you’re investing through an online broker. Many online brokers grant you commission-free ETF trading with your account.
If you’re a new investor with less capital to spend, this might be the most advantageous aspect of bond ETFs. You won’t have to pay the high up-front costs or the maintenance fees that are required of individual bonds.
Cons of Bond ETFs
Bond ETFs do have a few drawbacks. Here are a few of the big ones.
High Expense Ratios for Actively Managed ETFs
1. High Expense Ratios for Actively Managed ETFs
While passively managed bond ETFs have low expense ratios, actively managed bond ETFs have very high ones. Bond ETFs tend to pay steady interest rates, but the rates aren’t particularly high. The expense ratio could wind up eating away a good portion of your interest earnings.
While stock ETFs are typically cheaper than mutual funds, the reverse is true with bonds. Bond mutual funds tend to be cheaper than an actively managed bond ETF.
2. Low Returns
Since you won’t own any of the bonds that are part of the fund, your returns will be relatively low. Most bond ETFs passively reflect a market index—while most indexes appreciate in value, they don’t appreciate significantly.
Actively managed bond ETFs are more likely to generate higher returns, but you’ll have to deal with the high expense ratio—which may or may not be worth it, depending on how the fund performs.
This is why a bond ETF should only make up a portion of your investment portfolio. The main benefit is not that you’ll be earning high returns—it’s that you’ll be earning steady and reliable returns. Most investors want to develop a passive income on their earnings and have money regularly entering their bank accounts, even if one of their investments fails. Bond ETFs are a good option for investors who want to do just that.
The 5 Best Fixed Income ETFs to Invest In
What are the best fixed income ETFs to invest in? Here’s a quick list of bond ETFs that are low-cost and which generate solid returns.
iShares Core U.S. Aggregate Bond ETF (AGG)
Vanguard Total Bond Market ETF (BND)
iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
Vanguard Total International Bond ETF (BNDX)
SPDR Bloomberg Barclays 1-3 Month T-Bill ETF
1. iShares Core U.S. Aggregate Bond ETF (AGG)
This is the largest bond ETF on the market, a whopping $79 billion fund. The fund contains bonds from across the entire U.S. bond market, with over 8,000 total positions. It includes federal and local government bonds, and corporate bonds from both small and large companies. It’s also the most liquid bond ETF, given how large it is.
2. Vanguard Total Bond Market ETF (BND)
Vanguard also offers a huge and well-diversified bond fund that contains about $60 billion in assets. The Vanguard fund holds about 18,000 positions, more than twice that of the iShares fund. It also includes a higher ratio of U.S. Treasury bonds, which makes it less risky.
3. iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
This is a riskier bond that doesn’t include any government bonds—it only includes corporate bonds that have higher earnings potential. Some of the corporate bonds included are Anheuser-Busch, CVS, and Microsoft, so you can be confident that the companies will meet their repayment obligations.
4. Vanguard Total International Bond ETF (BNDX)
Here’s a bond ETF that includes roughly $30 billion in international bonds. Japanese, French, and German bonds make up the highest ratios of the fund, while there are fewer U.S. bonds—which means this is a good bond ETF to invest in if you already have plenty of U.S. holdings.
5. SPDR Bloomberg Barclays 1-3 Month T-Bill ETF
Longer-term bonds present more risk for investors, so if you have less risk tolerance you should look for a short-term bond ETF—like this one. This fund features a very small portfolio of just over a dozen bonds that mature within one and three months. It might be a good option for beginning investors who want to gain some experience investing in the bond market.
Fixed Income ETFs vs. Mutual Funds
What’s the difference between fixed income ETFs and mutual funds?
ETFs and mutual funds are similar in that they’re each a basket of securities. But there are two main differences. First, bond ETFs have higher liquidity than bond mutual funds. Second, many bond ETFs are passively managed, while bond mutual funds are actively managed.
Generally, a fixed income ETF may be more beneficial for day traders and beginning investors, while a bond mutual fund may be better for long-term investors.
As mentioned earlier, fixed income ETFs are traded throughout the day on stock exchanges, and the price fluctuates according to demand. While orders can be placed to buy or sell mutual fund shares all day long, orders are only processed at the end of the trading day. That means the price at the end of the day could be significantly different than the price you saw when you placed your order. This is more of a problem for investors who want to do active trading—it’s not such a problem for long-term investors).
Most bond mutual funds are actively managed, which means they have high expense ratios. Additionally, bond mutual funds tend to impose redemption fees or sales loads. Nonetheless, a bond mutual fund may be more beneficial for a long-term investor because it can generate stronger returns over a longer period. And if you’re not going to be trading frequently, you won’t have to deal with the trading costs or the lack of liquidity.
Bond ETFs vs. Bond Ladders
A laddered bond portfolio is an investing strategy in which you purchase a series of bonds that mature at different intervals. As each bond matures, you replace it with a new bond that may yield higher returns. It’s a popular fixed-income investing strategy and has been frequently compared to bond ETFs.
Bond ladders could generate higher returns for investors, simply because individual bonds generally yield better returns than ETFs. But individual bonds, as mentioned earlier, are often more expensive than ETFs and more difficult to purchase, so they’re not always a good investment option for beginning investors or investors who have less capital to work with.
A bond ETF is a cheaper and more convenient option for investors who want to trade on the stock market.
But you don’t need to choose between one or the other. Both bond ETFs and individual bonds (whether you employ the bond ladder strategy or not) are good investments for your portfolio. It’s tough to build a well-diversified portly without having some bond-related securities.
A fixed income ETF (commonly referred to as a “bond ETF”) is a type of ETF that only includes government or corporate bonds. Bond ETFs are traded on the stock market and provide the investor with steady—if not very high-yielding—returns. They might be a good option for investors who want to participate in day trading or who don’t have enough capital to invest in individual bonds. Bond mutual funds might be a better option for long-term investors.
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