Now that interest rates are up again, so is investors’ interest in bond ETFs. Bond ETFs are a great way to diversify your portfolio and earn you regular income with less risk than traditional investments. For more information on how to start investing in bond ETFs, see our guide here.
What are they in simple terms?
Bond ETFs, or exchange-traded funds, are investment funds that hold a portfolio of bonds and trade on a stock exchange. They are similar to traditional mutual funds, but they are traded like stocks and offer intraday liquidity, which means investors can buy and sell them throughout the trading day at market prices.
Bond ETFs can provide investors with exposure to a diversified portfolio of bonds, including government bonds, corporate bonds, municipal bonds, and high-yield bonds. They can also provide investors with access to different sectors, durations, and credit ratings of bonds. Bond ETFs can be a convenient and cost-effective way to invest in fixed income securities, as they typically have lower management fees and transaction costs compared to buying individual bonds.
Investors in bond ETFs receive income in the form of interest payments from the underlying bonds held by the fund. Bond ETFs may also offer potential capital appreciation if the market value of the bonds in the portfolio increases. However, it's important to note that bond ETFs carry risks, including interest rate risk, credit risk, and liquidity risk, and investors should carefully consider their investment objectives, risk tolerance, and the fund's prospectus before investing.
How do the work?
If the potential to earn a regular income with less risk than traditional investments sounds interesting, you’re going to want to learn more about fixed-income investments, such as bonds and bond ETFs.
Bonds are making a comeback with investors, and with good reason. While the returns you can get at your bank are only around 1.45% on average (in the UK at the time of writing), bonds can pay you from 4% and up, and will continue to do so straight through till maturity.
What are fixed-income investments?
Fixed-income investments include government and corporate bonds, certificates of deposit and some funds.
A bond is a tradable instrument that represents a loan made by an investor to the issuer of the bond (which could be a government or corporation). In exchange for the borrowed funds, the issuer agrees to pay the investor a fixed rate of return over a specified period, at which time the bond “matures” and the principal investment (the amount of money the issuer agrees to pay the lender at the bond’s expiry, also called its face value or par value) is repaid.
Until the maturity date, fixed interest payments, called coupons or dividends, are paid regularly (usually monthly) to the investor in the meantime. This is where the term fixed-income investment comes from: when you purchase a bond, you are anticipating a steady income, whose terms have been set (“fixed”) in advance.
For the last several years, interest rates have been very low. Bond coupons are paid to investors based on fixed interest rates, so these were low as well. This combined with high inflation, which devalues a bond’s principal worth, made bonds a less attractive option for investors.
However, that is changing. Central banks across the globe have been raising interest rates to counteract high inflation. After years of low interest rates, fixed-income investments are now offering higher returns.
This shift towards higher yields in fixed-income investments may be seen as a positive development for investors.
Moreover, interest rate hikes have negatively affected the stock market. During such periods of market volatility and uncertainty, fixed-income investments may be an appealing choice for investors seeking to lower the risk in their portfolios.
The benefits of bond ETFs
There are two main approaches to investing in bonds: investing in individual bonds or investing in bond ETFs (exchange-traded funds).
Investing in individual bonds involves purchasing a specific bond issued by a company, government, or other entity. This provides investors with a fixed interest rate and a specific maturity date. If held until maturity, the investor will receive the face value of the bond, which is the initial investment, plus the accumulated interest payments.
Investing in bond ETFs involves buying shares of a fund that consists of a portfolio of numerous bonds. Bond ETFs offer the benefits of diversification, since they hold a variety of bonds issued by different entities. Bond ETFs also offer what is known as liquidity — they can be bought and sold throughout the trading day. Rather than having a set investment period until the bond matures, bond ETFs can generate returns while affording investors the ability to quickly and easily adjust their exposure to the bond market at any time.
Choosing between investing in single bonds or bond ETFs depends on an investor’s individual circumstances, preferences, and investment objectives. Investing in individual bonds may be appropriate for those who have a specific investment horizon and are seeking a predictable income stream.
Bond ETFs may be more suitable for those looking for diversification and liquidity in their fixed-income investments.
Many retail investors may find investing in bond ETFs more accessible, as they demand significantly less capital than investing in individual bonds.
Ultimately, investors should consult with an independent financial advisor and carefully consider their investment goals, risk tolerance, and other factors before making a decision.
Terms to know
Here are some key terms to know when investing in bonds:
Bond market: The market where bonds are bought and sold, including both primary markets where new bonds are issued and secondary markets where existing bonds are traded.
Face value: The amount of money that the bond issuer will repay the investor when the bond matures.
Coupon rate: The fixed rate of interest that the bond issuer will pay to the investor, expressed as a percentage of the face value.
Maturity date: The date when the bond will expire and the issuer will repay the investor the face value of the bond.
Yield to maturity (YTM): A measure of the expected annual rate of return on a bond if it is held until its maturity date and all interest payments are reinvested at the same rate.
Duration: A measure of a bond’s sensitivity to changes in interest rates. Bonds with longer durations are generally more sensitive to changes in interest rates than bonds with shorter durations.
Call option: A provision in some bonds that allows the issuer to redeem the bond before its maturity date. This can be advantageous for the issuer if interest rates have fallen since the bond was issued, as they can issue new bonds at a lower interest rate.
Credit rating: A letter rating provided by credit rating agencies to assess the creditworthiness of the bond issuer, which can reflect the ability and likelihood of repayment. Higher rated bonds are generally considered to be less risky.
Default risk: The risk that the bond issuer will be unable to repay the investor the face value of the bond. Bonds issued by companies or governments with lower credit ratings generally have higher default risk.
The different types of bonds
Treasury bills (T-Bills) are short-term debt securities issued by the US government, sold at a discount relative to their face value. That means you pay less than what the bill is worth, and when it matures, you get the full face value back.
T-Bills come in different maturity periods, such as 4, 8, 13, 26, and 52 weeks. Generally speaking, the shorter the duration of a bond, the less likely it is to meet with much volatility. So, if you invest in a T-Bill with a shorter duration, you’ll have a lower risk of losing money if interest rates change.
TIP: T-Bills can be a useful complement to higher risk assets such as stocks. They provide a means of preserving capital and earning a predictable return. Just remember, like any investment, there are risks involved, so do your research and invest wisely!
Long duration bonds are backed by the US government — which makes them a very safe investment option — with a maturity of 10 years or more.
Although long duration bonds may be exposed to higher volatility in price compared to short duration bonds, you can still expect to earn a solid return on your investment in the long run.
TIP: Changes in interest rates, inflation, and currency fluctuations can impact the bond’s value. But as long as you understand the risks and are willing to hold onto your investment to maturity date for the long haul, long duration bonds could be a worthy low-risk addition to your portfolio.
Corporate bonds are issued by companies, rather than by governments. They may, therefore, carry credit risk, unlike government bonds which are considered very safe. However, to compensate for the increased risk, they offer higher yields.
With corporate bonds, you will want to pay extra attention to bond ratings, which evaluate the likelihood that the interest and debt on the bond will be repaid. Be aware of certain investments, such as junk bonds, which are rated Ba1/BB+ or lower, indicating particularly high risk.
TIP: One of the advantages of investing in bond ETFs is the diversified exposure to many instruments — which would reduce the impact of a single entity defaulting, if that should happen.
Putting it all into practice
The US bond market is the world’s largest, with a total value of over $50 trillion, consisting of three main bond types: treasury securities, corporate bonds, and mortgage-backed security (MBS) bonds. There are obviously many opportunities for fixed-income investments in a market of this size.
For an example of how you could gain diversified exposure to the US bond market as an investor, let’s look at the Vanguard Total Bond Market ETF (BND). The BND is the world’s largest fixed-income fund with over $80 billion of assets. This fund invests in a diverse range of bonds, from short-term government bonds with low risk to higher risk corporate and mortgage bonds.
In providing exposure to the entire universe of investment-grade rated US bonds, the BND offers a one-stop investment solution:
A yield to maturity of 4.3%*
Average duration of 6.6 years
Maintains a high credit quality by investing only in investment-grade rated bonds
Benefits from a very low expense ratio of 0.03%
Includes over 10,000 individual holdings, ensuring a well-diversified portfolio
The risks: what you need to know
It’s important to remember that, like any investment, bonds do carry risks. And you should consider them before investing:
Interest rate risk: Bonds are sensitive to changes in interest rates, and as interest rates rise, bond prices tend to fall, and vice versa. Therefore, if you hold a bond and interest rates rise, the value of your bond may decrease.
Inflation risk: Inflation can erode the purchasing power of the fixed interest payments received from a bond, which may result in a loss of value for the investor.
Call risk: This risk arises when an issuer decides to “call back” or redeem the bond before its maturity date. This may result in the investor receiving less than the expected return. This risk will usually not affect you when investing in an ETF since there is diversification.
Liquidity risk: This is the risk that the bond may not be easily tradable or that there may not be sufficient buyers in the market at the time of the sale, which may result in the investor receiving a lower price than expected. This risk will usually not affect you when investing in an ETF since there is high liquidity vs in a single bond.
Credit risk: This is the risk that the issuer of the bond will default on their payments. Credit risk is higher for bonds issued by companies with lower credit ratings or for bonds issued by countries with less stable economies.
It is important to consider these risks and the potential impact on your investment before investing in bonds.
Bonds are the world’s most traded asset class, with a global estimated worth of around $130 trillion. Although they fell sharply out of favour with investors in recent years when hit by the double whammy of record low interest and high inflation, this has actually opened up new opportunities now that interest is rising.
Bond ETFs can present an especially attractive opportunity for investors, as they combine the advantages of bonds as an asset with those of an exchange-traded fund, particularly diversification and liquidity.
Investing in bond ETFs (Exchange-Traded Funds) can provide a convenient and low-cost way to gain exposure to a diversified portfolio of fixed-income securities. Here are the steps to invest in bond ETFs:
Open a brokerage account: To invest in bond ETFs, you'll need to open a brokerage account with a reputable broker. Consider factors such as fees, trading platform, and investment options when choosing a brokerage.
Determine your investment objectives and risk tolerance: Before investing, it's important to identify your investment goals and risk tolerance. This will help you choose the appropriate bond ETFs that match your investment objectives.
Research bond ETFs: Look for bond ETFs that meet your investment objectives and risk tolerance. Consider factors such as the ETF's expense ratio, asset allocation, credit quality, and duration.
Purchase the bond ETFs: Once you have identified the bond ETFs you want to invest in, place an order to buy the ETFs through your brokerage account. Make sure you understand the trading fees and commissions involved in the purchase.
Monitor your investments: Keep an eye on your bond ETFs to ensure they continue to align with your investment goals and risk tolerance. Rebalance your portfolio as needed to maintain your desired asset allocation.
Remember to always do your due diligence and consult a financial advisor if you are unsure about any aspect of investing in bond ETFs.