In this bear market, investors are grasping at straws for stable securities that can deliver solid returns. Though investors do tend to gravitate toward bonds in times of volatility, Vanguard is highlighting the attractiveness of bond ETFs in particular.
A financial advisor can help you assess whether bond ETFs are right for your financial strategy. Try matching with a financial advisor for free.
What Are Bond ETFs
Exchange-traded funds, or ETFs, are financial instruments that combine the blended assets of a mutual fund with the liquidity of a stock.
In a nutshell, ETFs are portfolio assets. This means that each fund holds a portfolio of underlying assets such as stocks, bonds, derivatives or real estate. The fund’s performance is based on the combined performance of its underlying assets. Each investor, in turn, receives a return based on their proportional ownership of the fund; own 1% of the fund’s shares, say, and you receive 1% of the fund’s returns.
While a firm can build ETFs out of any financial assets it chooses, most exchange-traded funds are structured around a target. They may focus on a specific industry, say, or a particular asset class. This is the case with fixed-income ETFs. These are exchange-traded funds built out of bonds. The goal of a fixed-income ETF is to generate consistent income from the interest payments made by the underlying bonds. The bonds generate interest payments and the occasional capital gains when the fund sells them, and on a regular basis the fund issues those payments on a pro rata basis to its shareholders.
This has become an increasingly popular way to invest, as the investment firm Vanguard recently noted. In the past five years investment in bond ETFs has more than doubled. As of June 2022, firms held more than $1.2 trillion in these funds, and on a daily basis anywhere from $40 billion to $60 billion worth of trading occurs.
Given this high interest, the team at Vanguard recently published four pieces of advice for investors looking to get into this field.
1. Look for a firm that understands the bond market.
Bonds are, as Vanguard writes, an “opaque market.”
One of the biggest recent financial developments has been the rise of individual, or “retail,” investors. Specifically, individual investors have been flocking to assets traditionally the domain of professionals and firms. The trouble here is that most people understand the financial markets through the lens of stocks. People generally understand what stocks are and how they work, from capped losses to centralized markets and real time pricing, and they instinctively expect other investments to work the same way.
So it’s important to understand that this isn’t the case. Bonds are their own asset class, and they obey their own rules. As Vanguard writes, “[w]hereas equities are traded on public exchanges and have real-time transparency into intraday pricing, individual bonds trade over the counter and can lack pricing transparency… [T]he over-the-counter trading makes it challenging for bond dealers and asset managers to pin down the sourcing of bonds and determine their fair-value prices.”
This can make bond markets more technical and more challenging than stocks. It’s important to find an ETF issuer that understands this and that has a real expertise when it comes to bonds.
2. Understand the difference between index replication and index sampling.
Both stock and bond ETFs are often built around an index, meaning an external benchmark that the fund will try to replicate. For example, you might invest in an S&P 500 index fund. In that case, the fund will be built to try and track the performance of the S&P 500. When it goes up 10%, ideally so will the fund and so on.
With stocks, many funds do this by simply holding all of the assets in their underlying index. Taking the example above, an S&P 500 index fund ETF might simply hold every stock that makes up the S&P 500 itself. That way, by definition, the fund will track that index.
Bond ETFs relatively rarely do this because of expense and impracticality. Instead they use a practice called “sampling.” This means that the fund attempts to hold a representative mix of assets. Ideally the fund will hold investments that track its benchmark, leading to representative performance.
Before you invest, look at the history of your fund’s performance. How closely has it tracked its benchmark over time? Sampling can work well when a firm gets the asset mix right, but make sure they do get it right.
3. Stock and bond ETFs are assessed differently.
Every traded asset has what’s known as the bid-ask spread. This is the difference between the asset’s bid price (the price that buyers will pay) and its ask price (the price a seller will accept). The market price per share for an ETF, whether it’s built of stocks or bonds, is based on the midpoint between these two values.
At the close of each day, an ETF also has to calculate its net asset value, or NAV. This is the value of the fund’s total assets minus its liabilities. For example, a fund might collectively hold assets worth $200,000 and owe $50,000 on purchases that it made. In that case its net asset value would be $150,000. This is critical information because it tells shareholders how much value they own per share.
Stock and bond ETFs calculate their net asset value differently. With a stock ETF, the net asset value is calculated based on the market prices of each underlying equity. As a result, the NAV is based on the midpoint of the bid and ask prices for its whole portfolio. But because the bond market is less centralized, it calculates its net asset value only using the bid prices for its underlying assets. Since bid prices are typically lower than ask prices, this means that bond ETFs tend to have lower net asset value and, as a result, the per-share value appears higher with a bond ETF than with a stock fund.
This can make it look like bond ETFs have an unusually large gap between their market price and their asset value. This is an artifact of how prices are calculated, not necessarily a reflection of true value. A good way to correct for this is to pay attention to the consistency of a fund’s per share net asset value and how it compares with other bond-oriented ETFs.
4. Pay attention to the fund’s return structure.
A fixed-income ETF can generate two main forms of return. Most of your return will come from interest payments issued by the fund’s underlying bonds. Some of the return, however, can come from capital gains as the fund buys and sells these assets. That particularly will happen when funds sell bonds that are nearing maturity.
This isn’t necessarily a bad thing, but it can lead to tax disruption, depending on how you’ve planned your own finances. Make sure you pay attention to how much a fund has generated in capital gains over the years. Is this a fund that trades actively, or is it one that tends to hold assets over longer periods of time? Does it have bonds with longer maturities or shorter maturities? This can tell you how much you can expect to generate in capital gains from your fund, which in turn can inform your tax planning.
The Bottom Line
Fixed-income ETFs are funds that are made up of bonds. These have exploded in popularity and can be a great source of income investment, but it’s important to understand how they work. For example, be sure you know what index sampling is and how changes in prevailing interest rates affect the value of these securities.
Tips for Investing
- Now that you understand how bond funds differ from their stock-based counterparts, here’s how you can find and invest in them.
- Consider working with a financial advisor as you evaluate fixed-income securities in your portfolio and how they fit – or don’t fit – into your investment strategy. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Funtap, ©iStock.com/Renata Angerami, ©iStock.com/Torsten Asmus