While investing in ETFs, you must learn about the various ETFs that trade in the exchange. As an investment option, the ETF has gained significant popularity recently for their low cost and high liquidity. This article is going to talk about bond ETF and why an investor needs it in their portfolio.
Bond ETF is one of the types of ETF schemes available for investing. As the name suggests, the underlying for the bond ETF is various debt tools and debentures. These are exchange-traded funds that exclusively invest in bonds. As a product, these ETFs are pretty similar to bonds mutual funds because they hold bonds with different strategies.
At the core, bond ETFs are different from other ETFs. It is because the underlying is a bond. Bonds are usually fixed-income assets and aren’t liquid like other instruments. Investors hold bonds till maturity and do not usually trade them in the secondary market like stocks and indexes. Moreover, the prices of bonds are not traditionally available in the market. Hence, these are not as transparent as other ETFs. But to function like other ETFs, bond ETFs need to be liquid and add transparency to their pricing. Once bond ETFs are structured, they are the most viable and beneficial investment option.
- Bond ETFs are like ETF funds that track a correlating bond index.
- These are exchange-traded funds that invest in various fixed-income generating securities like government and corporate bonds.
- These are passively managed funds that allow retail investors to invest in bond indices in inexpensive ways like ETFs.
- These are available in various bond categories such as Treasuries, corporate, convertible, and floating-rate bonds.
- These can be used for laddering. Laddering is a technique of combining different investment strategies to create a steady flow of income. It is often a common technique adopted by bond investors by investing in bonds with various maturity periods.
- Like for any other investment, investors should appraise themselves of the risks associated with bond ETFs.
Understanding bond ETFs
Bond ETFs are pretty popular because they allow general investors to explore the vast bond market. They trade in the stocks exchange throughout the day like typical ETFs. They are better than traditional structured bonds, which are not readily available in the market, and difficult for investors to find bonds that offer attractive returns. Bond ETFs avoid these problems by trading in prominent exchanges. Moreover, these are more liquid than individual bonds and mutual funds.
Investors earn a steady income through monthly interest payments. Dividend income is taxed according to the income tax slab of the investor.
Types of bond ETFs
Depending on underlying assets, bond ETFs have various sub-sectors, such as,
- Government bond ETFs (including bonds issued by the central and state government and municipal authorities)
- Corporate bonds
- Junk bonds
- International bonds
- Floating rate bonds
- Convertible bonds
- Leveraged bonds
Who should invest in bond index funds?
People saving towards short-term goals invest in bond ETFs.
Bond ETFs are an easy way to invest in the bond market to earn a steady income, functioning like regular bonds creating a steady flow of income through interest payment. These low-risk, low-cost investments suit investors who are not seeking too much risk exposure but at the same time want to enjoy high liquidity from their investment.
How does the bond ETF work?
Bond ETFs work like an ETF and are tradable in the stock exchange. As a product, it promises low-risk investment, creating a steady source of income for the investors. However, bond funds are intermittent, meaning not readily available for trading in the market. But once these funds grow in popularity and more funds become available in the market, this problem will get eliminated.
The second issue with these investment tools is liquidity. Bonds as investment tools are not liquid and bond ETFs with underlying bonds also have restricted liquidity. However, investors can avoid this problem by selecting bond index funds that invest only in the most liquid bonds.
Benefits and drawbacks of investing in bond ETFs
The primary advantage of bond ETF is the chance of earning a regular income. Most bonds pay interest every six months. Typically, these ETFs contain bonds with different coupon payment dates, creating a stream of interest-earning.
However, the challenge with bond ETFs is that bonds have fixed tenure and exit, like equities. As a result, an active secondary market doesn’t exist for bond ETFs. It makes it difficult to encompass enough liquid bonds to track an index. The problem is more apparent with corporate bonds than government bonds. To resolve the liquidity problem, bond ETFs track the performance of a representative sampling, which means tracking only a sufficient number of bonds present in the index.
Secondly, bond ETFs don’t have a fixed maturity date, meaning there is no assurance of full repayment of the initial investment. It makes investing in bond ETFs riskier than purchasing individual bonds.
Another factor that can impact performance on bond ETFs is rising interest rates like it does for individual bonds. However, since bond ETFs don’t mature, it is hard to mitigate the risks of rising interest rates.
Bond index fund vs bond mutual funds
Investors looking for exposure in the bond market can select between bond mutual funds or ETFs depending on their investment objectives. Bond ETFs as products are still at a nascent stage, whereas bond mutual funds offer more investment choices. But if one wants more transparency and high liquidity, then bond ETFs are better. However, if you are concerned about not transacting bond ETFs in the market due to lack of demand, then choose bond funds.
The bottom line
Bond ETFs are low-cost options to get exposure in the bond market. However, the bond ETF market is still emerging and represents only a tiny fraction of the vast bond market. Recently, SEBI has decided to revamp the corporate bond segment and create a vibrant secondary bond market. It will develop a database for corporate bonds accessible to all investors. It will boost the bond mutual funds and ETFs. However, investment is an individual decision, and we recommend that you do research or ask your financial advisor before selecting.