Bond ETFs: Meaning, Types and Benefits

While investing in ETFs, you must learn about the various ETFs that trade in the exchange. As an investment option, the ETF has gained significant popularity recently for their low cost and high liquidity. This article is going to talk about bond ETF and why an investor needs it in their portfolio. Bond ETF is one of the types of ETF schemes available for investing. As the name suggests, the underlying for the bond ETF is various debt tools and debentures. These are exchange-traded funds that exclusively invest in bonds. As a product, these ETFs are pretty similar to bonds mutual funds because they hold bonds with different strategies. At the core, bond ETFs are different from other ETFs. It is because the underlying is a bond. Bonds are usually fixed-income assets and aren’t liquid like other instruments. Investors hold bonds till maturity and do not usually trade them in the secondary market like stocks and indexes. Moreover, the prices of bonds are not traditionally available in the market. Hence, these are not as transparent as other ETFs. But to function like other ETFs, bond ETFs need to be liquid and add transparency to their pricing. Once bond ETFs are structured, they are the most viable and beneficial investment option.

Key takeaways

Bond ETFs are like ETF funds that track a correlating bond index.
These are exchange-traded funds that invest in various fixed-income generating securities like government and corporate bonds.
These are passively managed funds that allow retail investors to invest in bond indices in inexpensive ways like ETFs.
These are available in various bond categories such as Treasuries, corporate, convertible, and floating-rate bonds.
These can be used for laddering. Laddering is a technique of combining different investment strategies to create a steady flow of income. It is often a common technique adopted by bond investors by investing in bonds with various maturity periods.
Like for any other investment, investors should appraise themselves of the risks associated with bond ETFs.

Understanding Bond ETFs

Bond ETFs are pretty popular because they allow general investors to explore the vast bond market. They trade in the stocks exchange throughout the day like typical ETFs. They are better than traditional structured bonds, which are not readily available in the market, and difficult for investors to find bonds that offer attractive returns. Bond ETFs avoid these problems by trading in prominent exchanges. Moreover, these are more liquid than individual bonds and mutual funds. Investors earn a steady income through monthly interest payments. Dividend income is taxed according to the income tax slab of the investor.

Types of Bond ETFs

Depending on underlying assets, bond ETFs have various sub-sectors, such as,

Short-term Bond ETFs: These ETFs include bonds that mature in a few years or less. They are relatively unaffected by interest rate changes, making them lower risk.
Intermediate-term Bond ETFs: These ETFs contain bonds that mature between a few years and 10 years. They usually offer higher returns than short-term bond ETFs and are more sensitive to interest rate changes.
Long-term Bond ETFs: These ETFs focus on bonds with maturities ranging from 10 to 30 years or more. They typically offer higher interest rates compared to shorter-term bonds and are very sensitive to changes in interest rates, rising when rates drop and falling when rates increase.
Total Bond Market ETFs: This type of ETF provides exposure to a mix of bond maturities—short, intermediate, and long. It offers a broad and diversified bond portfolio, balanced across different durations.
Investment-grade Bond ETFs: These ETFs invest in high-rated bonds that are considered safer, thus generally yielding less than those containing lower-quality bonds, such as high-yield bonds.
High-yield Bond ETFs: Also known as junk bond ETFs, these invest in bonds with lower credit ratings. The bonds range from moderate to low quality, reflecting their higher risk, but they typically yield more than investment-grade bond ETFs.
Municipal Bond ETFs: These ETFs invest in bonds issued by state and local governments that often provide tax advantages. Income from these ETFs is usually exempt from federal taxes, and if the bonds are from your home state, from state taxes as well.

Who Should Invest in Bond Index Funds?

People saving towards short-term goals invest in bond ETFs. Bond ETFs are an easy way to invest in the bond market to earn a steady income, functioning like regular bonds creating a steady flow of income through interest payment. These low-risk, low-cost investments suit investors who are not seeking too much risk exposure but at the same time want to enjoy high liquidity from their investment.

How Does the Bond ETF Work?

Bond ETFs work like an ETF and are tradable in the stock exchange. As a product, it promises low-risk investment, creating a steady source of income for the investors. However, bond funds are intermittent, meaning not readily available for trading in the market. But once these funds grow in popularity and more funds become available in the market, this problem will get eliminated. The second issue with these investment tools is liquidity. Bonds as investment tools are not liquid and bond ETFs with underlying bonds also have restricted liquidity. However, investors can avoid this problem by selecting bond index funds that invest only in the most liquid bonds.

Benefits and Drawbacks of Investing in Bond ETFs

Here's a simplified overview of the benefits and drawbacks of bond ETFs:

Pros of Bond ETFs:

Ease of Management: Bond ETFs handle interest payments from their bond holdings themselves, providing a steady income stream without the need to track the maturity and redemption dates of individual bonds.
Regular Income: Many popular bond ETFs distribute dividends monthly, enabling investors to plan their monthly budgets around these consistent payments.
Instant Diversification: Investing in a bond ETF can immediately diversify your portfolio, both in general and specifically within the bond segment. This diversification can stabilize returns and reduce risks compared to a portfolio made up solely of stocks.
Specific Market Segments: Bond ETFs allow investors to target specific segments of the bond market, such as short-term, intermediate-term, or long-term bonds. This flexibility helps in crafting a less volatile investment portfolio.
Simplified Investment Choices: Investors can avoid the complexity of analyzing individual bonds and instead select ETFs that align with their desired bond types, streamlining the investment process.
Cost Efficiency: Generally, the bond market is less liquid than the stock market and buying individual bonds can be costly due to wide bid-ask spreads. Bond ETFs leverage the purchasing power of fund companies to obtain better pricing, thus reducing costs for individual investors.

Cons of Bond ETFs

Higher Expense Ratios: The fees charged for managing bond ETFs might reduce the effective yield from the investments, particularly if these fees are high compared to the income generated by the bonds.
Potentially Low Returns: With historically low interest rates observed in recent years, the returns from bond ETFs might not be very high, particularly for those that passively track an index. Although actively managed funds might offer higher returns, they also come with higher management fees.
No Principal Guarantee: Like most market investments, bond ETFs do not guarantee the principal invested. If the market moves unfavourably, especially with long-term bonds in a rising rate environment, the value of the ETF could drop significantly. In such cases, fixed deposits (FDs) backed by the Deposit Insurance and Credit Guarantee Corporation (DICGC) might be a safer alternative for those seeking guaranteed principal up to ₹5 lakh.

Bond Index Fund vs Bond Mutual Funds

Investors looking for exposure in the bond market can select between bond mutual funds or ETFs depending on their investment objectives. Bond ETFs as products are still at a nascent stage, whereas bond mutual funds offer more investment choices. But if one wants more transparency and high liquidity, then bond ETFs are better. However, if you are concerned about not transacting bond ETFs in the market due to lack of demand, then choose bond funds.

The Bottom Line

Bond ETFs are low-cost options to get exposure in the bond market. However, the bond ETF market is still emerging and represents only a tiny fraction of the vast bond market. Recently, SEBI has decided to revamp the corporate bond segment and create a vibrant secondary bond market. It will develop a database for corporate bonds accessible to all investors. It will boost the bond mutual funds and ETFs. However, investment is an individual decision, and we recommend that you do research or ask your financial advisor before selecting. Start investing in Bond ETFs by opening a Demat account with Angel One today!