Bond ETF

Bond ETF Meaning

Bond ETF (Exchange Traded Funds) is a fund that invests in various bands ranging from long term and short term to corporate bonds and government securities. Just like a mutual fund, the Bond ETF is an exchange-traded fund that invests in a basket of bonds, including government bonds or corporate bonds. The Bond ETF is traded on the exchange, unlike bonds issued in a private placement or an over the counter market.

Types of Bond ETFs

Depending on the underlying bonds that the fund invests in, the types can be segregated as below:

Bond ETF

#1 – Sovereign or Government Bond ETF

Sovereign or Government Bond ETFs consists of bonds issued by the Government. These investments are rated high since the Government issues it, and hence the returns on these bonds are a bit lower. As it is rightly said, the higher the risk, the higher the returns. The interest rates on these securities are way too short, and the tenure of these securities is long.

Examples
  • Mortgage Back Securities ETF – These ETFs are backed by a pool of real estate mortgage loans and allows banks to offer mortgages.
  • US Treasury ETF – This type of ETFs includes the Treasury bonds issued by the US Government, these bear the minimum risk, and hence the returns are also minimized owning to this.
  • Treasury Inflation-Protected Securities ETF – As the name suggests, this ETF protects the investors from an increase in inflation. The principal value of the fund increases or decreases in line with the CPI, which means if the inflation shoots, so will the value of the fund.

#2 – Corporate Bond ETF

Corporate Bond Exchange Traded Funds consists of bonds issued by organizations whose proceeds are used for business operation or project refinancing depending on the requirement of the organization. Since private organizations issue these, the bonds are considered to be risky and hence fetch higher returns. When compared to stocks, bonds are less risky because in case the issuer becomes bankrupt, the dues pending for the bondholders are paid before the stockholders.

Examples
  • Investment Grade ETF – Bonds with ratings AAA to BBB are referred to as Investment Grade bonds, which are considered high credit ratings. This means the risk of the issuer to default is very low, and hence the return is a bit low compared to other Corporate Bond ETFs.
  • Junk Bond ETF – As the name suggests, these are bonds issued by organizations with a weak credit rating and have a higher chance of defaulting. These ETFs have a variety of Junk Bonds and hence offer higher yields, not to mention the higher risk involved due to the credibility of the issuer.

#3 – Broad Market Bond ETF

This is the most popular type of bond exchange-traded funds since it offers many bonds in one fund that includes sovereign bonds to corporate bonds. Since these have various bonds in the fund, investing in such funds reduces the risk of completely losing out on the investment, making a pathway for a long term investment option with returns at regular intervals.

Example

The Unconstrained Bond Exchange Traded Funds allows the fund manager to invest in bonds across geographies, markets, credit ratings, and currencies, thereby making the fund apt to reap the maximum benefits. Since the fund manager has the freedom to invest in any bond they desire, they can look for the bonds with the best returns at the lowest possible cost. Owing to this freedom, the Unconstrained Bond ETF can be more expensive than other Bond Exchange Traded Funds.

Advantages of Bond ETF

The following are the advantages of Bond Exchange Traded Funds.

  • Allows investors with limited capital to invest in the bond market, which otherwise can turn out to be a costly affair.
  • Limited risk as compared to stocks or mutual funds since the Bond ETFs invest in bonds, and in case of bankruptcy, the bondholders are paid before the stockholders.
  • Alternative investment option for investors who are looking to invest in low-risk securities for long term returns.
  • The interest payment is paid monthly, and capital gains are delivered through an annual dividend.
  • Even when a specific bond is underperforming, the investor can recover from the investment made in a basket of bonds through Bond ETFs.
  • Bond Exchange Traded Funds are available globally.

Disadvantages of Bond ETF

Here we discuss some of the disadvantages of bond Exchange Traded Funds.

  • The risk of losing the principal amount is higher in investing in a bond ETF since the Bond Exchange Traded Funds that have no maturity does not guarantee that the total principal amount will be repaid.
  • The change in interest rates affects the price of the ETF, and hence it becomes challenging to mitigate interest rate risk.
  • Investing in a Bond Exchange Traded Funds requires sound knowledge about how bonds function since the investor needs to understand whether investing directly in a bond is a better option than investing in a Bond ETF.
  • Since it carries a low risk, the returns are minimized compared to the potential returns that can be earned by investing in stocks.

Important Points

  • iShares Investment Grade Corporate Bond is the largest Investment Grade Bond Exchange Traded Funds.
  • Some Bond Exchange Traded Funds can be an alternative to money market investment since it provides the flexibility of short and ultra short term fixed income ETFs.
  • Since the Bond ETFs are exchange-traded like stocks, It has attractive properties like stocks – annual dividends.
  • Bond Exchange Traded Funds can be bought and sold in the open market depending on the demand in the market for the ETF.

Conclusion

Bond Exchange Traded Funds are passively managed funds that invest in a plethora of fixed income securities and are traded on an exchange. Bond ETFs charge a lower amount than the actual bond, thereby allowing investors with lower capital to invest in the bonds, which can be pricey. Some Bond ETFs have a pre-determined maturity date ranging from 3 years to 10 years and are known as target maturity bond ETFs.

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