Takeaways
- Bond ETFs are pools of passively or actively managed capital that invest in bonds.
- Bond ETFs can be dedicated to corporate, municipal, or international bonds.
- Bond ETFs allow investors to create bond ladders and secured interest payments.
- Bond ETFs give investors broad exposure without taking concentrated risk.
- Bond EFTs fixed-income investments are subject to inflation and interest rate risk.
What Is a Bond ETF?
A bond ETF is a type of exchange-traded fund (ETF) dedicated to bond investments. Bond ETFs are pools of investment capital dedicated to investing in a particular class of bonds. They trade on major stock exchanges, like the NYSE or Nasdaq, and are popular investments because of their broad exposure to bonds, low-cost structure, and passive investing approach.
Bond ETFs are considered a type of fixed-income investment. These funds typically narrow their focus to investing in one type of Bond—corporate, municipal, international, or green bonds—but spread their investment across many bonds within that category.
For example, corporate bonds ETFs invest in a basket of corporate bonds instead of a single corporate bond. This diversification allows you to invest in various bonds without the hassle and risk of purchasing individual bonds. You can also buy Bond ETFs that have exposure across different types of bonds.
Bond ETFs are incredibly popular with investors with a more conservative risk tolerance trying to amass a steady stream of passive income from bond interest payments.
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How a Bond ETF Works
A bond ETF is a passive form of investing in a basket of bonds preselected by portfolio managers to provide a diversified investment set aligned with the fund's specific strategy. Some bond ETFs might focus on high-yielding bonds or U.S. Treasury Bills, while others concentrate on international bonds. While most funds are passively managed, some are actively managed.
The Bond ETF tracks the performance of a specific underlying bond index or, conversely, a group of select bonds. Its price fluctuates based on inflation, the federal funds rate, individual bond risk, and macroeconomic forces.
You can purchase bond ETFs through an online stock brokerage account. To trade a bond ETF, investors buy and sell shares of the fund on the exchange. Ownership of a bond ETF share represents proportional ownership of each bond in the fund.
The income generated by the bonds in the ETF, mainly interest payments, is distributed to shareholders through monthlydividends. At the end of the year, all capital gains are paid to investors via annual dividends.[1] Bond ETFs offer the benefit of high liquidity since they can be quickly and easily traded, like stocks, allowing you to buy or sell shares during regular market hours.
This significantly differs from trading individuals' bonds, which are far less liquid and more challenging to trade, especially over the counter or thinly traded markets. Bond ETFs also have the added benefit of transparency, like daily holdings disclosures, which can mean more confidence in your investments.
Who Invests in Bond ETFs?
Investors choose to invest in Bond ETFs because, at the end of the day, they offer digestible, transparent, and diversified bond portfolios. Here are different types of investors that allocate a portion of their portfolios to Bond ETFs:
- Retirement Investors tend to focus on capital preservation. For those nearing retirement, allocating a portion of their holdings to Bond ETFs creates fixed-income portfolios to ensure guaranteed income. (Read more about how to retire early).
- Institutional Investors manage millions or billions of dollars in investment capital. They use Bond ETFs to level out diversification amongst the different asset classes, risk management strategy, and increase yield during rising interest rates. (Read more about institutional investors).
- Pension Funds invest in Bond ETFs because they offer low-cost solutions to gain exposure to many types of bonds and implement low-cost investing strategies. (Read more about pension funds).
- Endowment Funds can allocate a portion of their principal to Bond EFTs to lock in a low-cost and low-risk investment and use it as a counterweight to their other assets in the fund. (Read more about endowment funds).
- Retail Investors are everyday investors who manage their portfolios or work with a financial advisor. Retail investors slate a portion of their investment portfolio to Bond ETFs, especially when they don’t want to take on the additional risk of individual bonds. Retail investors and stock traders tend to be heavily allocated to stocks, real estate, or cryptocurrencies.
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5 Types of Bonds ETFs
There are as many Bond ETFs as there are types of bonds, but here are five commonly deployed strategies:
1. Government Bond ETFs
These funds are focused mainly on government-issued bonds, such as U.S. Treasury bonds or bonds from other stable governments. U.S. government bonds are considered risk-free because the full faith and credit of the U.S. government backs them. Other government bonds are generally regarded as low-risk investments.
2. Corporate Bond ETFs
These ETFs include bonds issued by C corporations, from mainly publicly traded companies who want to access the debt capital markets by issuing bonds to raise capital (instead of issuing common stock).
Corporate bonds typically offer higher yields than many government bonds because the bondholder assumes more credit risk. This risk varies depending on the company's creditworthiness. Bond rating agencies like Moody's and Standard & Poor's rate the quality of corporate bond issuances, with the highest rating being triple-A.
3. Municipal Bond ETFs
Municipal bond funds invest in bonds issued by state and local governments. Interest on these bonds is often exempt from federal income taxes, making them incredibly attractive to wealthier investors.
Municipal bonds are issued to raise capital for local projects and renovations and to fund government agencies.
4. International Bond ETFs
International bond ETFs give exposure to bonds issued by international governments and corporations. These bonds are prized for their geographic diversification and generally higher yields because they are perceived to be riskier than U.S.-based bonds.
International bonds face unique geographic and geopolitical risks, which investors must consider when purchasing them.
5. Short-term and Long-term Bond ETFs
Bond ETFs can also be categorized based on the duration of the bonds. Here is how the two categories are generally split:
- Short-term Bond ETFs concentrate on bonds that mature in one to five years. These bonds can be spread over U.S. T-bills, high-yield corporates, green bonds, and more.
- Long-term Bond ETFs focus on bonds that mature in at least ten years. Portfolio managers like to create diversified funds with the same term length, exposing the fund to various geographies, industries, and sector focus.
Pros of Bond ETFs
Bond ETFs offer many advantages that appeal to a wide range of investors. Here are some primary reasons you should add Bond ETFs to your portfolio:
- Diversification: One of the most significant benefits of Bond ETFs is that they add investment diversification to your portfolio. Because bonds tend to move independently of stocks, they give your portfolio a new risk and return profile. By adding exposure to a broad portfolio of bonds, the risk associated with holding individual bonds and stocks is greatly reduced.
- Highly Liquid: Liquidity is another massive benefit of bonding ETFs. While individual bonds are more difficult to trade, bond ETFs can be traded instantaneously on major stock exchanges during the trading day. This gives investors more flexibility and injects liquidity into your online stock brokerage account.
- Low-Cost Structure: Bond ETFs are usually passively managed investments, which means portfolio managers are minimally involved aside from the initial bond basket construction. This makes for a very cost-efficient structure and lower management fees compared to actively managed bond mutual funds.
- Transparency: The Securities and Exchange Commission (SEC) regulates Bond ETFs.[2] The SEC requires regular disclosures and transparency. Because Bond ETFs are traded like stocks, you can see which bonds you own on a daily basis.
- Dividend Payments: Another significant pro of bond ETFs is that they offer an avenue for a regular and predictable source of passive income. Bond ETFs can have higher yields than high-yielding savings accounts, depending on interest rates. Regular monthly and annual dividend payments can help investors focused on building income, such as retirees or those preparing for retirement.
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Cons of Bond ETFs
Despite the lineup of benefits, bond ETFs also have a range of potential drawbacks you should consider before adding them to your portfolio.
- Interest Rate Risk: Interest rate risk is the risk that the value of a bond decreases when interest rates go up. Since bond prices generally move inversely to interest rates, when rates rise (see federal funds rate), the value of bonds held within the ETF can decrease, potentially leading to a decline in the ETF’s share price. Shorter-term investments, like U.S. T-Bills, have lower interest rate risk than longer-term securities.
- Credit Risk: Even though you are not investing in individual bonds, you still have exposure to credit risk. Credit risk is the possibility that a company or international government may default on its bond payments, resulting in capital loss and loss of future interest payments. This risk is typically higher with high-yield or corporate bonds than government bonds.
- Lack of Control: Many investors also worry about the lack of control. When you invest in a bond ETF, you cannot choose the individual bonds, so you must rely on the fund manager's selections. For more control over what you invest in specifically, you can purchase one of the different kinds of bonds.
- Potential Lower Returns: Investors might earn a higher rate of return on other investments. Bonds typically have lower rates than well-performing high dividend-paying stocks, real estate investment trusts (REITs), or Bitcoin.
Smart Summary
Bond ETFs are exchange-traded funds that invest in a basket of bonds. Most Bond ETFs track a bond index and are passively managed, which reduces their fee structure. Investors flock to these investments because they inject diversity to their portfolios, provide passive income, and are generally stable investments. Bond ETFs can be bought and sold throughout the trading day, making them highly liquid. Consult your financial goals and with your financial advisor to see if a Bond ETF makes sense for your investment portfolio.
Frequently Asked Questions
One major benefit is that they simplify investing. You can purchase a Bond ETF through your online stock brokerage account.
The bonds in a Bond ETF pay investors interest payments, which are called dividends when distributed to bond ETF investors. Additionally, when bonds increase in value and are sold, they generate a capital gain, which is paid out to Bond EFT investors at the end of the year, as an annual payment.
Bond ETFs do not yield as high as other investments during periods of low interest rates and low inflation. However, as interest rates rise, bonds pay high interest, generating a higher return for institutional and retail investors alike.
(1) U.S. Securities and Exchange Commission. Mutual Funds and ETFs. Last Accessed January 14, 2025.
(2) U.S. Securities and Exchange Commission. Investor Bulletin: Exchange-Traded Funds. Last Accessed January 14, 2025.
