As interest rates have gone up over the last 18 months, many investors have become more interested in adding bond exposure to their portfolios. Bonds are essentially loans you make to a company or government on which you’ll be paid interest over a set amount of time (known as time to maturity, at which point interest payments stop and you get your principal back). As you may already know, there are a few different ways to invest in bonds: you can buy the bonds themselves or you can invest in a bond ETF. Bond ETFs have some advantages relative to bonds, along with a few tradeoffs.
If you’re considering investing in bond ETFs, either by choosing them yourself or through a product like Wealthfront’s Automated Bond Portfolio, it’s important to understand how they work. Here’s an overview of the basics to get you started.
What are bond ETFs?
Bond ETFs, like all ETFs, are pooled investment securities that hold multiple underlying assets and trade on exchanges during the trading day. The underlying assets in a bond ETF—we can call them a “basket”—are bonds. When you buy a share of a bond ETF, you’re buying a small slice of the basket of bonds chosen and held by the fund. This means you don’t have to go through the hassle of identifying, vetting, and managing the bonds yourself. Bond ETFs can also be more convenient than bonds because most of them don’t mature—when you own a bond ETF, you don’t have to keep buying new bonds to replace bonds that have matured.
Bond ETFs provide diversification, even with small dollar amounts
Buying a share of a bond ETF is a low-cost and convenient way to achieve diversification, which is the practice of buying a variety of different investments with the goal of balancing risk and reward in your portfolio. Bond ETFs help with diversification because you’re getting a small piece of hundreds or thousands of different bonds, often from different issuers or with different amounts of time until maturity, all for the cost of one share of the ETF.
Here’s an example to illustrate this point: the Vanguard Short-Term Corporate Bond ETF (VCSH) holds about 2,500 bonds. Building a diversified portfolio of corporate bonds like the ones in VCSH would require millions of dollars, but investors can get exposure to this basket for less than $80 through the ETF.
Bond ETFs are liquid
Liquidity is generally a good thing for investors: when an investment is liquid, that means it’s easy to sell it when you want to cash out. Bond ETFs are typically quite liquid because unlike most bonds, they trade on exchanges. Bonds generally trade over the counter (meaning there’s no central exchange or broker) and in some cases may not trade for weeks or months at a time. It’s also worth noting that some bonds, depending on how you purchase them, may have holding period requirements or penalties for selling early, but bond ETFs do not.
Bond ETFs pay dividends
Bond ETFs periodically pay cash, known as dividends, to investors. In fact, most of the earnings bond ETFs produce over the long run will come from dividends, although some might also come from price appreciation (more on that below). Dividends come from the interest collected from the bonds in the “basket” held by the ETF. As the bonds in the ETF make interest payments to the ETF issuer, the ETF earns cash which it typically pays out to shareholders early each month (with the exception of January—it’s typical to get a payment in late December instead).
Bond ETFs fluctuate in price
Bond ETF prices change daily along with the price of the underlying bonds. Bonds can fluctuate in price for a few reasons—and two of the biggest are interest rates and default probability, which is the likelihood that the bond issuer won’t be able to make its scheduled payments. Keep in mind that not all bonds respond to these factors in exactly the same way.
- Interest rates: When interest rates, or expectations about future interest rates, rise, the price of existing bonds tends to fall because most bonds have fixed coupon payments (regular interest payments occurring before the bond matures). In other words, when rates rise, prices fall so that the yields of existing bonds match those of new bonds. The converse is also true.
- Default probability: When market conditions worsen, default risk increases, resulting in a decline in bond prices. Again, the converse is also true.
Where bond prices go, bond ETF prices tend to follow. The price of a bond ETF will typically remain close to the value of the bonds it represents.
It’s worth noting that when dividends get paid out from a bond ETF to investors, the fund’s price will typically go down a little because that cash was previously reflected in the price of the fund. The day this happens is known as the “ex-dividend date” or just the “ex date.” A few days later, investors who own shares of the ETF get their share as a cash dividend, and they can either keep the income or reinvest it.
There are multiple ways to measure the performance of bond ETFs
There are several ways to measure earnings from bond ETFs. Here are a few we think are the most helpful and important.
- 30-day SEC yield: 30-day SEC yield is one way to measure the rate at which an ETF earns interest from its underlying holdings. It’s an annualized metric based on the last 30 days’ worth of interest. 30-day SEC yield is calculated by taking the total interest earned from an ETF’s portfolio for 30 days, subtracting ETF expenses, and dividing by the maximum share price of the fund on the last day of that period. Finally, this number is annualized. At Wealthfront, we take this a step further and calculate what we call “blended 30-day SEC yield” for our Automated Bond Portfolio. The blended yield is the weighted average of the 30-day SEC yields of the underlying ETFs in the portfolio minus our 0.25% annual advisory fee.
- Dividend yield: Another way to measure the rate at which an ETF earns interest is dividend yield. Dividend yield is calculated by dividing the ETF’s dividends over the past year by its current share price. Keep in mind that dividend yield may not always match the ETF’s 30-day SEC yield, which can understandably be confusing for some investors. If the SEC yield is higher than the dividend yield, that doesn’t mean you’re missing out (nor does it mean you’re getting anything extra if the SEC yield is lower).
- Total return: Total return for a bond ETF factors in both the yield of the underlying bonds and any changes in price of the ETF (which can go up or down). It’s an effective measure of overall performance, but it is different from the blended 30-day SEC yield because it includes changes in the market value of the ETF (which can be due to factors like changing interest rates). Total return may or may not be annualized, so you’ll want to be careful if you’re comparing it to a figure like 30-day SEC yield which is annualized. Total return can be calculated using a time-weighted or money-weighted approach. If you only make a single deposit, they’ll be the same.
Bond ETFs have an expense ratio
Just like stock ETFs, bond ETFs have an expense ratio. An expense ratio expresses an ETF’s annual operating expenses divided by the ETF’s assets under management. A significant component of the operating expenses is the fee charged by the ETF’s investment adviser to manage the fund. An ETF’s expense ratio is one factor to consider when you’re evaluating an ETF. The lower the expense ratio, the less operating expenses reduce the ETF’s assets under management, and the more of any potential returns you get to keep.
Some bond ETFs have tax advantages
Just as some bonds have tax advantages, bond ETFs can have them too. In some cases, the dividends you earn from a bond ETF may not be subject to federal and/or state taxes. For example, interest payments from U.S. government bond ETFs aren’t subject to state taxes (but they are still taxed at the federal level). And you generally won’t have to pay federal taxes on interest from municipal bond ETFs.
Here are some key things to remember about bond ETFs.
- Bond ETFs hold baskets of bonds and are more diversified than buying a single bond.
- Bond ETFs allow you to skip the hassle of identifying, vetting, and managing individual bonds for yourself.
- Bond ETFs are often more liquid than the underlying bonds.
- Bond ETFs pay dividends to investors, generally near the beginning of the month.
- Bond ETF prices fluctuate with the value of the underlying bonds.
- There are a few ways to measure a bond ETF’s performance, including 30-day SEC yield, dividend yield, and total return.
- As is the case for other ETFs, you’ll bear the cost of the fund’s operating expenses through the ETF’s expense ratio.
- Some bond ETFs have tax advantages.
If you’re interested in getting started with bond ETFs, Wealthfront has done the hard work for you with our Automated Bond Portfolio, which makes it easy to take advantage of the yields bonds offer without sacrificing liquidity or diversification. The Automated Bond Portfolio holds a mix of treasuries and corporate bond ETFs optimized to your tax situation, and is designed to provide a higher yield than our Cash Account while maintaining a lower risk than our Classic and Socially Responsible Automated Investing Account portfolios. It’s an ideal place to save for financial goals in the next one to three years (like a down payment on a house, an upcoming wedding or vacation, or a home renovation) or to invest in a lower-risk way for the long term.
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The characteristics of bond ETFs and individual bonds mentioned are generally applicable but can vary based on market conditions, underlying assets, and other factors. Investors should carefully assess the risks associated with bond ETF investments. Bond ETF liquidity is not guaranteed under all market conditions and diversification does not ensure profit or protect against loss. Bond ETF performance may not precisely mirror the underlying index due to tracking errors from factors like bond weighting differences, transaction costs, and timing. Management fees can affect overall returns. Bond ETFs expose investors to risks, including interest rate risk, potentially leading to capital losses as rising rates decrease underlying bond values. Most bond ETFs lack a fixed maturity date or guaranteed principal repayment at maturity.
Bond ETFs may generate capital gains from portfolio rebalancing, potentially resulting in unexpected tax liabilities. Credit risk is a concern, as bond issuers’ financial health can impact ETF value. Some bond ETFs may use derivatives, introducing counterparty risk where losses can occur if a counterparty fails to fulfill its contractual obligations. Call risk should also be considered, as falling interest rates might prompt callable bond issuers to repay securities before maturity, forcing reinvestment in lower-yield or riskier securities.
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About the author(s)
Alex Michalka, Ph.D, has served as Director of Investments of Wealthfront since May 2019. Alex earned a B.A. in Applied Mathematics from the University of California, Berkeley, and a Ph.D. in Operations Research from Columbia University. Prior to Wealthfront, Alex has held quantitative research positions at AQR Capital Management and The Climate Corporation. View all posts by Alex Michalka, Ph.D