Are Bond ETFs A Good Deal?

| About: iShares Core (AGG)
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There's an interesting chapter in The Radical Guide to Bonds by David Levine called "Are Bond Exchange-traded Funds [ETFs] Good For Bond Investors?". Here's the entire text (with his permission); see also more on bonds and bond ETFs:

What works for equities ETFs is also true for bond ETFs --- including, among other things, lower trading costs, exchange-traded prices, and diversification.

ETFs are smart investment vehicles. They solve some of the problems inherent in the mutual fund investment format. Primarily, unlike regular open-end funds, ETFs work well as shields against other fund shareholders’ churn ---namely, the inflows and outflows of invested cash in the fund caused by other shareholders. Taxable events are reduced.

Barclay’s iShares product offers the largest number of bond ETFs, six in all. The coverage is adequate and of a good credit quality for most investors. They are indexed to several major indices, covering broad investment-grade Lehman indices and even TIPs. Because of the difficulties in pricing the underlying securities, it will take some time before we see non-investment-grade bond ETFs.

Here are 3 takeaway points on indexed bond ETFs:

  • Costs can be favorable. Bond ETFs’ annual expense ratios are .15% to .20%, depending on credits and maturities in the bond index. These costs are a few basis points lower than the low cost Vanguard no-load indexed bond funds. From here, costs tend to escalate. That is, the more specialized the bond ETF, the higher the expense ratio. That makes sense, as more specialized funds (like international bond ETFs) require more monitoring and credit selection work.

    The other outsized cost is the brokerage commission. If you can buy or sell at a low $8 per leg, then a roundtrip trade is $16, or 8 bps on a $20,000 investment. You would have to hold that investment for two years to keep the overall costs inside that of a comparable indexed bond fund.

  • Distributions should be primarily interest income. In reviewing the distribution history of Barclay’s broad-based indexed bond ETF (NYSEARCA:AGG) no short- or long-term capital gains have been distributed; only interest has come back. The ETF shield limiting capital gains distributions seems to work.

    That does not mean, in fact, no capital gains will be distributed in the future. One clear exception may be with TIPs-indexed ETFs. For these, both income derived from the inflation adjustment to principal and the coupon will have to be paid out monthly. To cover the inflation adjusted principal payout, capital gains may have to be distributed.

    Still, it is broadly true that the meaningful distributions on indexed bond ETFs will be interest, not trading gains. ETFs should help to manage your tax bill better.

  • Additional trading costs may be passed on to you. As with the mutual funds, the annual ETF expense ratio does not include the trading costs incurred by the managers. For example, Barclays broadly --- emphasis is on this word --- states it will pay all operating expenses of the funds “except interest expense and taxes (both expected to be de minimis), any brokerage expenses, future distribution fees or expenses and extraordinary expenses." (pg. 21, Bond iShares Prospectus)

    These costs may be passed on to you.

So let’s try to bring these all together in the next chapter. We wrap this up the discussion with a simple comparison of all three vehicles.

Guide to Bonds Table of Contents
ETF Investing Guide