Basic Concept
Bond ETFs are a type of ETF that tracks the performance of a specific bond index, enabling investors to mitigate risks associated with investments at a lower threshold by bundling multiple bonds together. This investment tool is ideal for people looking to earn stable yields from the bond market. Bond ETFs are one of the fastest-growing segments in the fixed-income market worldwide. By the end of 2023, global bond ETFs had surpassed USD 1.5 trillion in assets under management (AUM), comprising almost 20% of the global ETF market.
Bond ETFs offer high liquidity through their operational mechanism. This mechanism allows investors to trade bond ETF shares on the secondary market just like stocks. Bond ETFs typically consist of different types of bonds—government, corporate, and municipal—creating a diversified investment unit. This reduces the credit risk of individual bonds and provides significant diversification across different economic cycles, resulting in more stable returns.
Advantages of Bond ETFs
One of the key benefits of bond ETFs is their liquidity. The traditional bond market often has low liquidity, especially during periods of increased volatility, when bond prices can fluctuate significantly. However, bond ETFs can be traded in the secondary market like stocks, allowing investors to buy or sell on any trading day, ensuring asset liquidity. Based on 2023 figures, major global bond ETFs generally traded $10 billion or more in daily volume, demonstrating that these funds are highly liquid.
Affordability is another key factor that attracts investors to bond ETFs. Bond ETFs generally have management fees ranging from 0.05% to 0.50%, much lower than those charged by actively managed bond funds. Lower costs can result in higher net returns, as they allow investors to reduce expenses over the long term. Holding bond ETFs long-term instead of individual bonds can save investors an average of 0.3%-0.4% per year in costs.
Another major benefit of bond ETFs is transparency. ETFs usually report their holdings and performance data daily, allowing investors to see their portfolios in real-time. This transparency gives investors greater assurance and control, particularly during unstable market conditions. According to a Morningstar survey, more than 85% of bond ETF investors said transparency was an essential factor in their choice.
Potential Risks
Market risk is a concern that every bond investor must confront. Although bonds are generally considered a stable investment choice, interest rate fluctuations can still cause significant price changes. According to historical data, if market interest rates rise by 1 percentage point, long-term bonds can fall in price by about 7%-8%, while medium- and short-term bonds may see a smaller decline of about 1%-3%. As such, investors should consider their interest rate risk exposure when selecting bond ETFs.
Liquidity risk becomes more apparent during times of heightened market stress. While bond ETFs themselves are generally liquid, the underlying bonds within those funds may not be. During periods of market turmoil, bond ETFs may be sold at a discount, leading to redemption pressures. For example, in the early days of the COVID-19 pandemic, bond prices swung dramatically, and some bond ETFs traded at more than a 3% discount, reflecting the real impact of liquidity risk during extreme stress.
Credit risk is mainly related to the credit quality of bond issuers. If the issuers of the bonds in which the ETF is invested face credit problems, it may lead to defaults. This risk is more pronounced in junk bond ETFs. In 2023, the default rate was just under 0.1% for investment-grade bonds, while it was about 3.5% in the high-yield bond market.
Suitable Investors
Bond ETFs are usually suitable for investors with low-risk tolerance who are seeking steady income. This makes them ideal for retirement portfolios or long-term investment strategies. Such investors often look for stable cash flow and capital preservation, two attributes that bond ETFs can achieve through a diversified basket of bonds. By 2023, the average dividend yield of bond ETFs ranged between 2%-3%, while high-yield bond ETFs offered dividend yields of 5%-7%, providing a stable source of income.
