For bond investors, exchange-traded funds (ETFs) might be the great equalizer.
“Bond ETFs have democratized the investment process by providing access to a pool of bonds with varying yields, maturities, durations and risk profiles,” says Ahmed Farooq, senior vice-president and head of retail ETF distribution for Franklin Templeton Canada in Toronto.
In any balanced portfolio, bonds can be an important tool – a way to generate modest income with relatively little risk. As an alternative to investing in individual bonds, many investors are turning to ETFs that hold a diversified basket of bonds.
The strategy can be prudent even at a time of high interest rates. Bond prices (what investors pay for bonds) and interest rates have an inverse relationship. As interest rates rise, bond prices fall, and vice versa.
That’s because bonds are typically issued at a fixed coupon rate, which is an obligation of the issuer to pay investors. When the market interest rate rises, bond prices fall and yields – the returns that investors get – rise. Yields are a function of interest rates and bond prices; the lower the price, the higher the yield.
As rates rose in recent months, bond ETFs have experienced losses. But bond yields have improved substantially as rates climbed higher. That has contributed to a marked improvement in bond return expectations, fuelling demand for bonds.
Depending on their investment objectives, investors can therefore use bond ETFs as a defensive strategy to stabilize their portfolios. “They can focus on the long-term total returns of bonds instead of prices,” says Sal D’Angelo, head of product with Vanguard Americas in Toronto.
Compared with individual bonds, bond ETFs offer several benefits. “One of the main reasons for the shift to bond ETFs was concerns about liquidity,” Mr. Farooq says. Bond ETFs trade on the market like stocks, giving investors intraday liquidity.
Cost is a factor too. “There is not a lot of price transparency for individual bonds, which can make it expensive for investors to buy them,” says Prerna Mathews, vice-president of ETF product strategy at Mackenzie Investments in Toronto.
She notes that buying individual bonds can require a minimum investment in the range of $1,000. As a result, most investors can only own a handful of them. Comparatively, investors can have access to a basket of bonds in an ETF for a much lower cost.
“Individual bonds can be difficult to buy and can result in quite a bit of transaction costs, which does not lead to the best outcomes for investors,” Mr. D’Angelo says. In an ETF, Ms. Mathews says, “investors benefit from lower-cost institutional pricing.”
On the income side, bond ETFs pay out monthly or quarterly income or dividends, while individual bonds pay out semi-annual interest. A bond ETF can be a smart way to set up a regular income stream without having to worry about the maturity and redemption of individual bonds, Ms. Mathews says.
By investing in a basket of bonds, investors also don’t have to spend time analyzing the characteristics and features of individual bonds. Bond ETFs include bonds that aim to represent the total market.
Other funds target specific segments such as investment-grade, short-term, long-term and high-yield bonds. Each type of bond responds differently to market conditions and interest rates, giving people flexibility in selecting the segment of the market that meets their investment objectives.
Risk management is a major consideration. Buying individual bonds can expose investors to concentration, credit and interest-rate risk, Ms. Mathews says. “These risks are harder to manage in different interest rate environments.”
Mr. Farooq adds that investors can manage risk through targeted exposure to specific segments of the market. For example, they can use a “barbell strategy” by pairing different ETFs such as short- or long-term bonds to meet their investment objectives.
Investing in a bond ETF that comprises the broad market might be an appropriate strategy for mitigating interest rate risks, Mr. D’Angelo suggests. When individual bonds mature, investors have to contend with reinvestment risk. “They can find it difficult to redeploy the proceeds in order to obtain a specific exposure,” he says. “They know what they are getting at all times when investing in a bond ETF.”