The Benefits and Risks of Bond Index Funds

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A bond index fund is a firm that buys bonds to match an index. It then creates securities from the bonds and sells them to investors. The index fund is designed to match the performance of an index, such as the Barclays Aggregate U.S. Bond Index.

You can buy index-related products like bond mutual funds, or you can choose from the growing number of exchange-traded funds (ETFs) traded through a broker. These products are a simple and cheap way to invest in bonds. Bond index funds are highly diversified, have low fees, and use an approach that’s easily understood by most people.

Bond index funds may well be a leading option for those who want to earn income from their investments.

Key Takeaways

  • A bond index fund is a firm that invests in a portfolio of bonds designed to match the performance of a particular index.
  • Index funds are passively managed, which means they have lower management fees. 
  • Index funds perform more consistently than actively managed funds.

Passive Management

Index funds differ from other ETFs and mutual funds in that they are passively managed. With actively managed funds, the manager tries to choose bonds that will outperform the index over time. The index fund simply holds the bonds that are listed on the index. In some funds, a sample of the bonds on the index are used. When the bonds listed on the index changes, the bond index fund's holdings change to reflect it.

Lower Management Fees

The “expense ratio” is the percentage of assets that the fund company skims off the top each year to cover expenses, pay employees, and earn a profit. Since index funds simply track an index, there are fewer costs to operate the fund. The fund can then pass those savings along in the form of low expense ratios.

There's also little difference between index funds, making it easy for you to shop around for your best option. While actively managed funds are highly dependent upon management's choices, all index funds that track the same index should hold similar investments and see similar performance. With that in mind, you can focus more in your search on the expense ratios among competing funds.

For examples of how much fees can differ, look at a few iShares ETFs from the BlackRock, Inc. The iShares Interest Rate Hedged High-Yield Bond ETF (HYGH) is an actively managed fund with a net expense ratio of 0.52%.

Small difference between fees may not seem worth the worry, but if you're investing over long periods the small amounts add up over time.

The iShares Interest Rate Hedged Emerging Markets Bond ETF (EMBH) is another actively managed ETF that tracks international bonds. This fund has a net expense ratio of 0.47%. On the other hand, look at an index fund like the iShares Core U.S. Aggregate Bond ETF (AGG); it has a net expense ratio of 0.04%.

You should also consider the impact of fees in today's low-yield environment. For example, if a fund’s portfolio only yields 4% on a given year, a 1% management fee wipes out about a quarter of your income.

Consistent Performance

With an index fund, you know what you’ll be getting. You'll see a return that is close to that of the broader market. However, active managers can create wide swings in performance. One year the manager can outperform the index by 2%, but next year, they may lag by 5%.

Not only are the results of actively managed funds more inconsistent than index funds, but over longer time frames, the majority of active managers lag behind index funds.

Hidden Risks

Some funds, like AGG, mirror broad benchmarks such as the Barclays U.S. Aggregate Index. In this type of fund, a large portion of the portfolio is government or government-related securities.

That comes with high levels of interest rate risk. When yields are falling, and bond prices rise, this is fine. If interest rates rise and your portfolio is full of government bonds, you'll see a large drop in value, and it will be hard to sell them. You may want to look for ways to augment your bond index funds with bonds with lower interest rate risk, such as high-yield and emerging market bonds.