Bonds vs. Bond ETFs

Jun 7, 2010 by

As people become more risk-averse, financial institutions have been rolling out bond exchange traded funds. While these funds serve a certain purpose, bonds are about as similar to bond ETFs as fruit is similar to fruit snacks. Sure, fruit snacks are “made from real fruit”, but their nutritional properties sure are different!

What is a bond?

Simply put, a bond is a debt contract with a company or municipality. The debtor agrees to either pay you a series of payments (coupons), a lump sum at the end (the par value), or a combination there of, in exchange for receiving money now that can be used to finance something. The risk that you take on is that if the debtor is unable to pay back the debt, you may only receive part of the money you are owed by the contract. Furthermore, you might try to resell the bond before its contract has been fully realized. If the interest rates change, you might get more (if the interest rates go down) or less (if the interest rates go up) than you had originally paid for it. If you plan on holding it until it matures (the contract has been completed), your only risk is that the company or municipality won’t be able to pay you back.

What is a bond ETF?

Two financial advisors suggested to me that I consider bond ETFs as a way of diversifying my portfolio with bonds. After analyzing the situation, I can’t think of a worse idea. One popular bond ETF is the “Vanguard Total Bond Market ETF” (BND). According to Yahoo! Finance’s summary:

The investment seeks to track the performance of a broad, market-weighted bond index. The fund employs a passive management, or indexing investment approach designed to track the performance of the Barclays Capital U.S. Aggregate Float Adjusted index. It invests by sampling the index. It invests at least 80% of assets in bonds held in the index. The fund maintains a dollar-weighted average maturity consistent with that of the index, ranging between 5 and 10 years.

Got that straight? What the misguided financial advisors thought that this does is provide me with a diverse portfolio of bonds that I could essentially buy a fraction of in order to decrease my risk. They thought that this would have a similar effect to my simply owning a diversified portfolio of bonds. These thoughts could not be further from the truth. As the summary flat out says, BND is designed to “track the performance of a broad, market-weighted bond index”.

What causes the value of that index to shift? Changes in the interest rate, as well as changes in the ratings (predicted default rates) of the underlying bonds. While a company in the portfolio might continue to make its payments as always, if the interest rate goes up, the resale value of that bond goes down. No one that plans to hold that bond to maturity cares about the resale value – that’s why bonds are a fixed income investment that provide senior citizens with the stability that they desire. But, if you are investing in an index whose value changes with the resale value of the underlying bonds, you are getting anything but a stable investment. Given that the Federal Funds Rate is 0.25% (as of June 7th, 2010), it can only either remain the same or go up. When it goes up, the resale value of bonds issued in the past will decline and this ETF will go down. So, investing in BND not only exposes you to the default risk of the bonds; it also exposes you to the risk that their ratings will change or that the interest rate will change. Not exactly a stable, fixed income investment after all.

So, how has BND performed?

5 Day Performance

3 Month Performance

1 Year Performance

As you can see from these charts, BND is anything but a stable, steady investment. Instead, it is a proxy for a rather volatile index. The beta of BND is 0.06, indicating that the direction in which BND moves is nearly perfectly uncorrelated with the movements of the stock market.

To Conclude

Bond ETFs differ from bonds in that bond ETFs expose you to the risk of changes in bond prices, in addition to the risk of bonds defaulting. Their behavior is far more like that of stocks than of the bonds that they contain. Bond ETFs are not a suitable investment for an investor looking for a stable, fixed income investment. They are, however, a great way to diversify a portfolio by exposing it to the resale price of bonds. Given the difficulty that small investors have in buying bonds (investments in a given issue of bond usually have approximately a $10,000 minimum for corporate and municipal bonds), they seem like an appealing way to diversify. But, they have different characteristics than bonds and investors should be aware of this.

As the yield of investment-grade bonds is now very low, I would recommend that people considering buying bonds who cannot afford to purchase a diverse portfolio of them to put their money in a high-interest savings account if they are seeking a stable, fixed-income investment. Interest rates will likely go up in the near future, and doing this will provide the ability to purchase bonds or CDs at more favorable rates of return in the future. Under no circumstances would I recommend a bond ETF to someone seeking an investment with a stable rate of return.

Note: Bond mutual funds appear to have the same behavior as bond ETFs. But, they tend to leave you worse off as they have higher management fees associated with them.

1 Comment

  1. Steeleadrian

    Yes I can see that a 'liability driven investor' is better off with a traditional bond ladder where both their income stream and their return of principal on a particular date is guaranteed (For high quality bonds with minimal credit rating at least).

    A long-term investor who is interested in portfolio diversification and stability over periods much longer than the duration of the bond ETF (typically 8 years) has quite a few advantages with a bond ETF though. Low trading costs, low spreads on bond pricing, access to bonds in esoteric markets, less credit risk due to large number of bonds in the ETF. For very long investment horizons the interest rate risk is not important as you suggest: as the shorter duration bonds in the ETF near maturity their price will approach the issue price and this will be reflected in ETF valuation.

    Although you are correct in highlighting the differences between a bond ladder and bond ETFs I think your emphasis is not quite right. For many investors bond ETFs are a great advance

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