Bond ETFs: the investment you need to know about when interest rates are high

Fixed-income assets can be a smart addition to your portfolio, earning regular income with less risk than traditional investments.

You probably already know that investing can be one of the best ways to reach your long-term financial goals. And while the stock market has great potential for significant returns over time, right now — with inflation still high and the economy in flux — many investors are shifting allocation to bonds yielding very high returns compared to the past decade’s average.

What are bond ETFs? 

Bond ETFs represent a category of fixed-income instruments that pool together individual bonds, providing investors with diversification and, therefore, reduced risk. This asset class offers a predictable and stable projected cash flow, typically in the form of dividends. Bonds are considered fixed income investments, so named because of the fixed rate (also known as yield to maturity) set at the time of investment.

Here’s what investors need to know:

• There are two main types of bond ETFs: corporate-backed and government-backed. 
• Bonds tend to be less volatile than other tradable asset types depending on their duration and credit rating.
• For many fixed-income securities, when they reach maturity investors are repaid the principal amount they invested, in addition to interest payments already received.
• In the event of default, whether by a company or government, payment to bondholders is settled before payment to shareholders.
• Unlike single bond, a Bond ETF offers diversification which further reduces risk and overall volatility.

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Pros and cons of Bond ETFs

PROS

CONS

Income Generation: Bond ETFs typically provide a steady income stream from interest payments, making them attractive for income-seeking investors. Diversification: Bond ETFs hold a basket of individual bonds from various issuers, providing instant diversification and reducing the risk associated with investing in a single bond. Liquidity: Bond ETFs trade on stock exchanges like regular stocks, making them highly liquid. Investors can buy and sell shares throughout the trading day at market prices.  Low Minimum Investment: Bond ETFs allow investors to access a diversified bond portfolio with a relatively low minimum investment, making them accessible to a wide range of investors.  Cost-Effective: Bond ETFs generally have lower expense ratios compared to mutual funds, making them cost-effective for investors.

Price Volatility: Bond ETFs are subject to price fluctuations based on changes in interest rates. When interest rates rise, bond prices usually fall, which can impact the value of the ETF. Credit Risk: Although bond ETFs aim to diversify credit risk by holding multiple bonds, there is still a risk of default by individual issuers, affecting the overall value of the ETF. Tracking Error: Some bond ETFs may not perfectly track their underlying bond index, leading to a difference between the ETF’s performance and the index it aims to replicate. No Maturity Date: Unlike individual bonds, some bond ETFs do not have a fixed maturity date, which can affect an investor’s ability to lock in specific interest rates. Limited Control: Investors in bond ETFs have limited control over the individual bonds held within the ETF, as the fund manager makes these decisions.

 

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When interest rates are high, consider bonds

For the last several years, the interest rates paid on bond coupons have been very low, because interest rates in general were at rock bottom. However, that has changed. 

• Central banks around the globe have been raising interest rates to counteract high inflation. 
• Although interest rate hikes have negatively affected the stock market, they’ve been a boon for bonds. 
• Bonds have the potential to earn you a regular income with less risk than traditional investments. 
• While the returns you can get at your bank are still low (only around 1.45% on average in the UK), bonds can pay you from 4% and up, and will continue to do so if held until maturity.

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It’s important to remember that, like any investment, bonds do carry risks. However, when compared to assets such as stocks, commodities or forex, bonds generally carry lower risk. Always check a bond’s rating to assess the issuer’s credit risk. For more on the benefits and risks of bond ETFs, read our guide to fixed-income investments here.

 

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