Bond ETFs have transformed the landscape of fixed income funds for investors. Consumers use bond funds as a way to diversify their fixed income exposure, similar to equities and mutual funds. This is very easy and inexpensive to do, however, there are both benefits and risks to consider when considering the addition of a Bond ETF in your portfolio.
Pros of fixed income ETFs include:
Portfolio Diversification – ETFs are a convenient way for investors to build a portfolio that meets specific allocation needs. An investor seeking 80% stocks and 20% bonds allocation can easily create that portfolio with ETFs.
Flexibility and Liquidity – Like traditional stocks and bonds, ETFs can be traded intraday. This means they provide tentative investors an opportunity to bet on the direction of shorter-term market movements through the trading of a single security.
Tax Efficiency – ETFs are a favorite among tax-conscious investors because the portfolios that ETFs represent are more tax efficient than index funds. The unique structure of ETFs allows an investor trading large volumes to receive in-kind redemptions. This arrangement minimizes tax implications for the investor exchanging the ETFs since the investor can defer most taxes until the investment is sold. Furthermore, because of the type of stocks they track you can choose ETFs that don’t have large capital gains distributions or pay dividends.
Low Expense Ratios –ETFs are a huge win when it comes to helping investors save a few dollars. They offer the benefits associated with index funds (low turnover, broad diversification) – plus they cost a lot less.
Cons of fixed income ETFs include:
Interest Rates Changes – Interest rates have been dropping for the past several years so people are typically receiving the increased prices for their bond funds. However as interest rates start to rise, that trend may be declining. Because of this, many people will see their bond funds go down in value for the first time in a long while. The speed at which bond prices decline will depend largely on their average duration.
Credit or Default Concerns – There is always a risk that the issuer will not be able to make interest and principal payments to bondholders. With that in mind, bonds with a lower credit rating typically offer higher interest rates in order to recompense investors for the additional risk.
Market Fluctuations – An overall market decline may negatively affect the value of individual issues even though those investments still have robust foundations.
The Effects of Inflation –Inflation is the rate at which purchasing power is decreased over time. If an investor has a bond for a long period of time before they see a return on their initial principal, there is a greater chance that rising inflation will reduce the value of the principal and the interest payments.
With all this in mind, it is important to make sure that you are receiving proper counsel before adding bond ETF’s to your portfolio mix. Remember that investment grade individual bonds are classified as a type 1 investment and bond funds are classified as a type 2 investment by the OCI. Consider discussing your investment options with an independent fee-only financial advisor who adheres to the fiduciary standard.