There are a lot of arguments as to why ETFs are advantageous over mutual funds, but out of all the different ETFs available, the benefits of exchange traded funds are probably most apparent when it comes to bond ETFs. So do you want to learn more about bond ETFs and how they work? Then this piece is for you.
- Bond exchange traded funds (ETFs) are designed to mimic an index or an underlying investment type.
- These ETFs pay out interest and monthly dividends, while their capital gains are paid out annually.
- Bond ETFs tend to be more liquid than bonds themselves because they must be transparent and available to secondary markets.
- There are numerous bond ETFs available so researching the best to meet your personal needs is key.
What Are Bond ETFs?
Just like other ETFs, bond ETFs seek to emulate a correlating index or underlying investment product. In the case with bond ETFs however, it’s not as simple as with other funds like oil ETFs or energy ETFs.
Bonds themselves are fixed income assets that are not very liquid. Most investors hold bonds until maturity and do not typically trade them on secondary markets like stocks and indexes. Also, pricing information is not traditionally transparent for bonds.
This is the opposite case for a bond ETF, which needs to be liquid, available to secondary markets, and transparent when it comes to historical pricing. So as you can see, bond ETF construction has a few obstacles to overcome. However, once the bond ETFs are designed, they work just like regular ETFs and track a correlating bond index or product.
How Do They Work?
As we said, bond ETFs need to be liquid so they can be traded on exchange floors. However, bonds are notorious for being illiquid. The workaround is that a bond ETF usually consists of only the largest and most liquid bonds in the underlying bond index. This gives the bond ETF the ability to emulate the index and be more “trader friendly” at the same time.
Also, bond ETFs pay out interest with a monthly dividend, even though capital gains are paid out on an annual basis. And while that does give bond funds the same tax advantages as traditional ETFs, it doesn’t play as big a role in bond ETFs because bond returns are not as heavily impacted by capital gains as stocks are.
There are many different bond ETFs to explore for your ETF investing strategy. International bond ETFs, corporate, government, short, medium, and long-term, and even junk bond ETFs. And while there are many types of ETFs in the investing world, there are many types of bond ETFs as well. See for yourself...
If you think you are ready to get started with bond ETFs, make sure you conduct thorough research first. Are you looking for a revenue stream, do you understand the tax implications, do you know which type of bond ETF is the best fit for your portfolio?
You need to answer these questions and many others. Research different types of bond ETFs like the iShares Barclays Aggregate Bond Fund (AGG) or the Vanguard Long Term Investment Grade Bond Fund (VWESX) and see how they react to market conditions. Understand the advantages and disadvantages of bond ETFs. Conduct your due diligence, watch how these funds react to different market conditions, take a look under the hood and see what is in the funds.
Once you have a firm grasp of the world of bond ETFs, only then is it time to include them in your portfolio. And that's when you should check out our list of bond ETFs. As with any investment, a company stock, an ETF, Index or otherwise, please make sure you thoroughly research this exchange traded funds on that list. And if you have any questions or concerns, make sure you consult a stockbroker, a financial advisor, or another financial industry professional.
While ETFs have many advantages, they have many disadvantages as well (as does any investment). So it is very important to understand the investment vehicle before you trade it. But once you have a full understanding on these Bond ETFs, you can consider adding either or both to your portfolio. And good luck with all of your trades!