Understanding bond ETFs

Bond ETFs are a type of investment that can add diversification to your trading portfolio, potentially reducing your overall risk exposure. This asset class also can offer attractive yields, offering a steady stream of revenue for investors and traders. Depending on your financial goals and strategies, bond ETFs may be a valuable addition to your acquisitions.

Get a head start on bond ETFs with this comprehensive guide. Understand the basic concepts, including the types of bonds, benefits, risks, and strategies.

What are bond ETFs?

Bond ETFs are a type of exchange-traded fund that invests in bonds. Like regular ETFs, bond ETFs track an underlying index and trade on major stock exchanges. The portfolios of bond ETFs contain various types of bonds, such as government bonds, corporate bonds, municipal bonds, and more. 

Bond ETFs provide an easy and low-cost way for investors and traders to gain diversified exposure to many different bonds in a single fund. It also holds baskets of hundreds or even thousands of bonds, just like bond mutual funds. However, unlike mutual funds, bond ETFs trade intraday on stock exchanges, providing continuous pricing and the ability to buy and sell anytime the market is open. 

6 types of bond ETFs

There are many varieties of bond ETFs available to suit different traders’ needs:

1. Total Bond Market ETFs hold a broad mix of investment-grade bonds, including government, corporate, mortgage-backed, and other types. These provide highly diversified exposure to the overall bond market.
2. Government Bond ETFs invest in debt issued by the US government and its agencies. This includes US Treasuries, agency mortgage-backed securities, and more. Government bonds are considered very low risk.
3. Corporate Bond ETFs hold investment-grade bonds issued by various corporations. These provide income streams through corporate debt. Both broad market and sector-specific corporate bond ETFs are available.
4. High Yield Corporate Bond ETFs invest in bonds rated below investment grade, also known as junk bonds. These carry more risk but offer higher income potential.
5. Municipal Bond ETFs hold bonds issued by state/local governments to fund projects. Interest income from muni bond ETFs is generally tax-exempt.
6. International/Emerging Market Bond ETFs invest in foreign bonds from both developed and emerging market countries. These help diversify currency and country risk.

Benefits of bond ETFs

Several advantages make bond ETFs an appealing investment for many investors and traders:

• Low cost: Bond ETFs have lower expense ratios than actively managed bond mutual funds because they are passively managed and do not require high research/trading costs. This saves investors money.
• Diversification: Owning a bond ETF provides instant diversification across hundreds or thousands of individual bonds. This reduces portfolio risk compared to holding individual bonds.
• Liquidity: Bond ETFs trade continuously on exchanges like stocks, so investors can buy and sell anytime during market hours. Bonds themselves tend to be less liquid.
• Transparency: Bond ETFs disclose their full holdings daily, providing portfolio transparency for investors. Holdings can also be tracked over time.
• Tax efficiency: Bond ETFs tend to have lower distributions than actively managed bond funds, leading to higher after-tax returns in taxable accounts.
• Convenience: Purchasing a bond ETF is much simpler than researching individual bonds. It allows small investors easier access.

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Risks and considerations

While bond ETFs have many positive attributes, there are some risks and considerations to keep in mind:

Interest rate risk 

The prices of bonds move inversely to interest rate changes due to their fixed-income nature. When interest rates rise, the prices of existing bonds fall to match the yields of newly issued bonds in the rising rate environment. The longer the bond maturity, the more sensitive the price is to rate changes. Bond ETFs with longer duration feel a greater impact when rates rise. For example, a 1% rate increase can cause a 25+ year Treasury bond ETF to fall by 20% or more. Being mindful of duration and managing interest rate exposure is crucial for bond ETF investors.

Credit risk

The credit quality and default risk of the underlying bonds are key risk factors. Bond ETFs holding investment-grade corporate and government bonds have minimal credit risk. However, those holding high-yield junk bonds have a greater risk of defaults, which can reduce income and principal. Individual bond defaults may not significantly impact diversified bond ETFs. But major downgrades and waves of defaults during recessions do affect overall returns. Choosing ETFs with higher-quality bonds can mitigate credit risk.

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Since bond ETFs aim to match index returns, not outperform, there will be some tracking errors. The ETF’s fees and expenses will cause a slight performance lag versus the index. Also, bond ETFs use sampling strategies to mimic indices rather than owning all the securities. This can lead to small performance deviations. Tracking error is usually minor, but investors should be aware.

Less customisation

Investors have less control over the specific bonds and individual weightings held in a bond ETF than trading individual bonds or actively managed funds. You must accept the ETF’s particular portfolio and weights. Some bond ETFs are highly diversified, while others target specific sectors, so customisation ability varies. Investors seeking more control can combine ETFs with individual bonds.

Liquidity risk

Bond ETF shares can be bought and sold easily on exchanges. However, some segments of the fixed-income market, like high-yield bonds, can become less liquid during periods of market unrest. This lack of liquidity in the underlying bonds can lead to larger bid-ask spreads and premium/discount pricing for the ETF.

Tax treatment

Like most ETFs, bond ETF distributions are taxed as income rather than the more favourable long-term capital gains rates. However, interest income from government and municipal bond ETFs is exempt from federal and state taxes, respectively. So, bond ETFs can fit well in tax-exempt retirement accounts or taxable accounts per the type of income.

Bond ETF strategies

Bond ETFs can be utilised in various ways within investment portfolios:

• Adjust duration: One way to manage interest rate risk is to adjust the duration of your bond ETF portfolio. If rates are expected to rise, rotate into shorter-term bond ETFs, which are less sensitive to rate changes. If rates are expected to fall, rotate into longer-term bond ETFs to benefit more from the price appreciation as yields decline.
• Fine-tune credit: You can tilt your bond ETF portfolio towards investment grade or high yield based on your credit risk preferences. Investment grade bond ETFs hold higher quality, lower risk corporate debt. High-yield ETFs hold below-investment-grade corporate bonds with more credit risk but potentially higher income. Adjusting allocation can manage your overall credit exposure.
• Access specific sectors: There are bond ETFs focused on specific sectors like corporate bonds, municipal bonds, and emerging market debt. Adding sector-specific ETFs provides exposure to those unique market segments for diversification and targeting sectors with attractive risk/return profiles.
• Satellite holdings: Specialised niche bond ETFs can be satellites to a core portfolio. Examples are Treasury Inflation-Protected Securities (TIPS) funds for inflation protection or floating rate funds for low-duration credit exposure. These targeted holdings allow you to fine-tune your broader bond allocation.
• Tactical shifts: Being tactical involves shifting exposures based on changing market outlooks. For example, reducing high-yield bond ETFs when spreads are compressed and adding to government bonds if rates are expected to fall. Taking advantage of relative valuations and cycles can enhance portfolio positioning.

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As we’ve seen so far

Bond ETFs have become a mainstream staple in investor portfolios due to their inherent benefits like low cost and diversification. They allow small and large traders to have easy access to the huge and diverse bond market. 

However, bond ETFs do carry risks like interest rate sensitivity, credit risk, and tracking deviation that should be evaluated. Overall, bond ETFs can be useful for passive core holdings, tactical shifts, accessing specific niches, and completing a fixed-income allocation. As with any investment, they should be researched carefully and used prudently within a balanced portfolio. Bond ETFs simplify investing in bonds while providing flexible exposure.

You can trade bond ETFs with markets.com

Are you looking for a platform that is user-friendly and tailored for both beginners and experienced traders alike? You can trade bond ETFs and other assets on markets.com. Our platform offers a contract for difference (CFD) trading option. In this type of trading, you will be speculating the price of your chosen bonds without having an actual asset. 

When deciding to trade bond ETFs, a CFD trading calculator will make calculating your hypothetical P/L (aggregated cost and charges) easier. Using our calculator, you can quickly evaluate any position you hold or are about to open by calculating its spread, margin requirement, overnight swap and more. 

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When considering “CFD bond ETFs” for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice."