Using exchange-traded funds to invest in bonds has been increasing in popularity lately: More investors are becoming comfortable with the ETF structure, and a dismal decade in stocks has sent many people into the perceived safety of fixed income.
But are ETFs the best way to get your bond allocation? How should you evaluate a bond ETF and see if it makes sense for you?
As with any ETF purchase, the first rule is to know what you own. Generally, bond ETFs track one of the major fixed-income indexes in the same way that many equity ETFs track an index such as the S&P 500. Bond indexes serve as proxies for segments of the fixed-income market, be it Treasury securities, corporate bonds, or municipal bonds. They often have massive numbers of securities, but ETFs hold only a representative sample. It would be unwieldy to hold all of the bonds, and oftentimes many of the issuances trade very infrequently, making them poor candidates for inclusion in an ETF.
Morningstar's ETF Analyst Reports can help you determine what index the ETF tracks and how well that ETF is following the index.
It's also crucial to understand how investing in a bond ETF is different than buying individual bonds. Simply put, bonds have maturity dates, whereas indexed bond investments do not.
That is to say, if you were to buy a 10-year IBM bond with a 3% yield, you'd know that for the next decade you're guaranteed to get a 3% yield and then you'll have your principal returned. On the other hand, a bond index that tracks 10-year corporate bonds will have a constantly moving yield as maturing bonds are replaced by new issuances.
The shifting yield of a bond ETF means that investors face constant interest-rate risk while the risk becomes smaller for individual bond investors as the security reaches maturity.
This means that fixed-income ETFs aren't great options for a liability-driven investment, such as saving for a child's college education. A laddered portfolio of individual bonds with specifically tailored maturities designed to offset a given individual's future liabilities could be a better bet.
To conceptualize a bond or bond ETF's sensitivity to a movement in interest rates, investors should refer to a metric called modified average duration. For example, if interest rates were to instantaneously rise by 1%, a bond ETF with a duration of 10 years would be expected to see a corresponding 10% price haircut. The drop in price of the bond compensates for the fact that newer bond issuances will be available at higher yields following an interest-rate hike.
You can find the duration of a bond ETF by looking at the portfolio section of the ETF report.
Bond ETFs can serve as a good place for investors looking for a short-term location to park some assets because the liquidity and low costs of ETFs makes it possible to get your money in and out quickly.
But investors should be aware that for the long term, bond ETFs are most suitable as complementary players in an investor's bond portfolio, perhaps between 10% and 30% of the total fixed-income allocation.
It's also worth keeping an eye on innovations in the bond ETF world. An increasing number of ETF providers now offer products with set maturity dates that return your capital after a set number of years instead of reinvesting to keep a fixed average maturity. New products like those could help make more bond ETFs more useful to long-term investors.
Morningstar research can help you keep track of these new offerings and give you the tools you need to see if they make sense for your investment criteria.