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.
- Government bond ETFs contain only US Federal Government bonds ("Treasuries" or "Treasury bonds"). Interest from Treasury bonds is usually exempt from state and local taxes (but be sure to check with your accountant).
- Inflation-protected bonds, such as TIPS (Treasury Inflation Protected Securities) pay interest equal to the consumer price index plus a premium. So inflation protected bonds tend to outperform regular bonds when projected inflation rises.
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.
- US government bonds are safer than corporate bonds but tend to offer lower returns. However, since interest on US Federal bonds is generally exempt from State and local tax, their after-tax return may be higher for some tax payers.
- Inflation protected bonds behave differently from other types of bonds (if expected inflation rises, the price of TIPS rises but the price of regular bonds falls), so they should be considered a separate asset class.
- If you decide to use more than one bond ETF in a portfolios, stick with a single ETF family (Ameristock, Barclays or State Street). Mixing ETFs from different families may lead to overlap between the ETFs.
- Short term bond ETFs are an alternative to money market funds. In many cases, they pay higher rates of interest than brokerages pay on cash.
- 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.
- Consider other bond ETFs that hold bonds with high credit ratings but may not be uniformly government bonds. See Broad US Bond ETFs for these 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.
- Discussion and comparison of these bond ETFs: Searching for the Best Bond ETF (Jonathan Bernstein), State Street Global Launches a Handful of Fixed Income ETFs (Matt Hougan), Ameristock Launches Five Targeted Treasury ETFs In Challenge To iShares Lehman (Matt Hougan), Replacing Barclays iShares Bond ETFs With Vanguard's New Bond ETFs (J.D. Steinhilber), Nuveen Muni Bond CEFs: Worth Considering Over Better Known Bond ETFs (Investing the Middle Way).
- For more about inflation protected bonds, see Why Investors Should Avoid TIP and the discussion in the comments below.
- For more discussion of the different types of bond ETFs, see Bond ETF Selection: A Quick Overview.
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.