Definition of Bond ETF
Bond ETF is an exchange-traded fund investment option that invests clients’ money into fixed interest securities. They mainly invest in corporate bonds and treasuries. These are low-risk investments and provide regular coupon payments on a monthly basis. Bond ETF helps the individual investor in getting exposure to bond benchmark indices, which they would not have been able to do otherwise.
Bond ETF are bought and sold on major exchanges which allow the investor to find attractive prices for their securities, unlike traditional bond which are bought and sold by the broker. It helps investors to gain exposure towards the bond market with the added benefit of transparency of stock trading. It also suggests that bond ETF is more liquid if compared to traditional bonds or mutual funds. Investors can buy or sell bond ETF anytime if the bond market is not performing well.
The return of bond ETF is paid in terms of monthly dividends, and any capital gains are paid annually. On the taxation aspect, bond ETF is subject to income and capital gain tax, but capital gain tax does not form a large part of the return, unlike share trading. Bond ETF does not form a major part of the bond market so if they do not perform very well, it will not necessarily impact the entire bond market.
How does it Work?
The below points can help us in understanding how does the bond ETF work?
- Bond ETF like traditional bonds provides the regular coupon payment. But unlike traditional bond that pays the interest on a half-yearly basis, bond ETF pays it on monthly basis and value of coupon also varies from month to month. The reason behind this is that bond ETF invests in different assets with different maturity dates, so every month some bond will be dues for coupon payment.
- The bond ETF manager keeps track of bond indices in a cost-effective manner, the task is a little complicated as most of the bonds are not liquid in nature and thus do not have a secondary market where they can be traded. Also, the asset in the bond ETF keeps changing and does mature, instead bond ETFs are bought and sold when they are expired.
- For index representation purposes most liquid bonds are selected which helps the bond ETF architect to get around the liquidity problem.
- Lastly as mentioned earlier, the bond ETF is subject to income as well as capital gain tax.
Example of Bond ETF
Some of the examples of the bond ETFs are as follows:
- Government Bond ETF: these are issued by the government, some of the examples are:
- Mortgage back securities ETF: the bond ETF is backed by real estate mortgage loans and helps banks in offering the mortgage loan.
- Us treasury ETF: they are issued by the US government, carry minimum risk and low return.
- Treasury inflated protected securities: In this bond ETF, the principle value increases or decreases in line with the consumer price index or inflation.
- Corporate bond ETF: These bonds ETFs are issues by corporate or private organizations. Examples are as below:
- Investment Grade ETF: In this category bond ETFs are issues according to different ratings for example bond ETFs with AAA or BBB ratings are considered as high credit rating bond ETF thus they carry a minimum risk of default and low return as well.
- Junk Bond ETF: These bond ETFs are issued by the company with a lower credit risk rating. They generally offer a high rate of return but the risk of default associating with these is also high.
Who Should Invest in Bond ETF?
The bond ETF is a low risk associated investment option. Therefore the investors who do not have a very high-risk appetite and are looking for security on the return perspective should invest in the bond ETF.
Also since bond ETF provides liquidity option i.e. investors can buy and sell them at the time of distress, therefore investors who are looking forward to the short-term investment or saving option should invest in bond ETF.
Advantages of Bond ETF
The advantages of the bond ETF can be understood from the below points:
- Bond ETF helps investors in diversifying their portfolio as it invests in various fixed interest assets with different maturity periods, like long-term, mid-term, and short-term.
- Bond ETF majorly invests in fixed interest assets thus provide its investors a low risk investing avenue.
- Unlike traditional bonds, bond ETF is liquid in nature and also allows its investors to reach the bond market as they are traded on stock exchanges.
- Bond ETF can cater to the exact risk-return of the client in terms of fixed asset securities. This happens because bond ETF comes in different forms which means that an investor can select bonds that they want to include in their individual portfolio.
- Bond ETFs are traded on stock exchanges thus they provide its investor the price transparency.
Disadvantages of Bond ETF
The disadvantages of the bond ETF can be understood from the below points:
- The investment manager fees associated with the bond ETF are too high if compared to the low return, it basically erodes the major part of the return.
- As bond ETF majorly invests in fixed interest securities, therefore they provide a low rate of return.
- Also if the interest rate rises the investor loses their chance to earn a better return on their initial investment.
Bond ETF is an accessible option for investors, investing in a traditional bond is very difficult for an individual investor. Thus in a way bond ETF has provided investors access to the bond market. It is a good investment option for investors who are looking for regular monthly income as well as liquidity.
This is a guide to Bond ETF. Here we also discuss the definition and how does bond ETF work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –