What Are They?
- Like bond mutual funds, bond ETFs provide exposure to bonds by tracking indexes with fixed duration. In other words, bond indexes contain bonds with various maturity dates, managed so that the entire index has a fixed average maturity. If projected interest rates rise, the price of a bond ETF falls.
- Broad bond ETFs contain a mixture of government (also known as "Treasury") and corporate (also known as "credit") bonds. The corporate bonds in these index ETFs generally have high credit ratings.
Why & How To Use Them
- Bonds are a core component of diversified portfolios, as they behave differently to stocks and therefore dampen volatility. Bonds are also safer (ie. less volatile) than stocks and generate interest income, making them particularly suitable for people in and nearing retirement. However, bonds tend to produce lower long-term returns than stocks, so younger investors who can tolerate more short-run volatility often opt for a low or zero allocation to bonds.
- Buying a broad bond ETF makes portfolio management easy. But you loose flexibility in two areas. First, broad bond ETFs don't allow you to manage duration. If projected interest rates rise, the price of bond ETFs will fall, and the longer the duration the greater the potential fall. Second, different types of bonds have different tax status, and broad bond ETFs don't allow you to pick the type of bonds that might be most suitable from a tax perspective.
- Broad bond ETFs tend to have low expense ratios.
What to Look Out For
- Individual investors and institutions can buy US Government bonds with zero transaction fees from Treasury Direct. The savings and superior control versus a bond fund may be worth the extra bother of managing a portfolio of individual bonds.
- As an alternative to these ETFs, consider also US government bond ETFs.
- Richard Kang argues in Vanguard Offers Four New Bond ETFs that bond ETFs should only be a "final option" for "complete novices". See also his articles Are Bond ETFs A Good Deal? and Why I'm Against Fixed Income ETFs, and Roger Nusbaum's Five New Bond ETFs, and Why They May Not Be for You. In contrast, Carl Delfield highlights The Advantages of Bond ETFs and Will McClatchy proves a Response to Roger Nusbaum on Bond ETFs.
- On the differences between Vanguard and Barclays bond ETFs, see J.D. Steinhilber's Replacing Barclays iShares Bond ETFs With Vanguard's New Bond ETFs and Comparing iShares' and Vanguard's Bond ETFs.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.