Bond ETFs are great tools for investing in different forms of debt. Here's what you gotta know before adding them to your portfolio.
Updated Jan 26, 2023
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Bonds
With the federal funds rate on the rise, more investors are looking to park their money in something safe. Bonds are some of the safest investment vehicles of the past century and treasury bonds are leading capital preservation asset in a market worth $46 trillion. The main benefit of bonds is that their market price is stable and they earn interest.
The easiest way to invest in bonds is by purchasing shares in a bond exchange-traded fund (ETF). Bond ETFs are like a basket of various bonds you can invest in, but each ETF will have different benefits, risks, price, and yield performance based on the type of underlying bond. Let's explore what bond ETFs are and how to get better investment results by balancing key risk factors.
A bond ETF is a fund that trades treasuries bonds, municipal bonds, or corporate bonds. Bonds are basically debt—it earns interest until it gets paid back—so a bond ETF forms when a fund holds different forms of debt as its underlying asset. Treasury bonds tend to perform better during a recession compared to the S&P 500, so you're more likely to get the best investment results from treasury bond ETFs.
Different types of bonds vary in terms of risk, interest yield, and holding period, meaning whether they are 'short' and mature soon or are 'long' and will take years or decades to payout investors. Treasury bonds are the lowest risk bonds and investment-grade corporate bonds are considered high risk. What makes corporate bonds riskier is that their prices are more volatile and companies are more likely to default on debt than governments. If you really like to gamble, high-yield corporate debt is the riskiest type of bond.
Treasury bonds are securities issued by the U.S. Federal Reserve that are basically interest-bearing IOUs from the federal government. Treasury bonds are traditionally considered to be the safest asset an investor can have since their principal value is guaranteed to be paid out when they mature after 10 to 30 years. Since U.S. treasuries are the underlying asset of treasury bond ETFs, their certainty is what makes treasury bond ETFs one of the safest investment instruments.
Most treasury bond ETFs use the interest they earn to pay investors semiannual dividends, but these are subject to federal income tax. This is why you should want to invest in treasury-backed ETFs with a low expense ratio. A good example of this is iShares U.S. Treasury bonds ETFs like IEF and TLT. Both charge a low 0.15% fee and are simple ways to invest in either short-term or long-term treasury bonds.
On the riskier side of the ETF spectrum is a corporate bond fund. The underlying asset of corporate bond funds is different forms of debt including commercial debt, such as mortgages or private student loans, or outstanding debt owed directly by the corporation. In other words, corporate bonds are any security backed by non-governmental debt.
This added layer of credit risk is what makes corporate bond funds more perilous.
However, there are varying degrees of risk among different types of corporate debt. Corporate bonds that are safer assets are considered 'investment grade,' while riskier ones are branded as 'non-investment grade' or 'junk' bonds. Junk bonds specifically refer to securities made of high-interest corporate loans that come with significantly more risk. All corporate bonds mature in one to 30 years, but most short-term corporate debt is referred to as commercial paper.
Corporate bond funds tend to perform well when the economy is strong and productive. Like treasury bond ETFs, dividends from corporate bond funds are taxed, so you'll want to invest in low expense ratio ETFs. AGG is one of iShares best investment grade bond ETFs, but Vanguard also offers ETFs for trading long- and medium-term debt like VCLT and VCIT. With 0.04% expense ratios, all of these funds are super cheap ways to invest in corporate debt.
ETF | Expense ratio | Market price | NAV price | YTD Returns |
|---|---|---|---|---|
AGG | 0.04% | $103.15* | ||
VCLT | 0.04% | $83.71* | ||
VCIT | 0.04% | $81.68* |
*Data gathered 7/28/2022
*Data gathered 7/28/2022
The market price of a corporate bond fund is different from its net asset value, which equals the value of the fund's assets minus liabilities divided by the number of shares. This matters because it's the gauge by which most traders measure a fund's performance. While net asset value works as a way to evaluate an ETF's past performance, it isn't always an indicator of what lies ahead for the fund.
The corporate bond market is more diverse than other bond markets in terms of risk and potential returns. There are several corporate bond ETFs that offer retail investors exposure to riskier corporate debt, but how it performs depends on the fund's investment strategy. For instance, a commercial paper ETF like ICSH is riskier than corporate debt funds, but this may be tolerable to some bullish investors who want higher returns.
ETF | Expense ratio | Market price | NAV price | YTD Returns |
|---|---|---|---|---|
ICSH | 0.08% | $50.06* | ||
HYG | 0.48% | $76.75* | ||
SPHY | 0.1% | $23.25% |
*Data gathered on 7/28/2022
Riskier yet is the HYG high-yield corporate bond ETF. This iShares ETF is one of the most popular ways for investors to get exposure to junk bonds, but it has a high expense ratio. A high yield bond ETF with a more reasonable expense ratio is SPHY with 0.1% compared to HYG with 0.48%. High-yield bonds tend to serve as good short-term investments when markets are bullish but perform relatively poorly over the long term compared to investment-grade corporate bonds.
If you're not into risky investing but treasury bond ETFs aren't thrilling enough, then municipal bond ETFs or 'munis' are a middle-of-the-road option. Municipal bonds are a little riskier than treasury bonds because they're backed by local government debt, but are exceptionally safer than corporate debt because they're usually paid back with state and local taxes. Another huge benefit of munis is that they're the only debt-backed securities not subject to federal income tax.
Municipal bonds are usually used to fund public works like parks, schools, and roads, so municipal bond ETFs are just a bundle of city, county, and state debt made into a tradable security. VanEck offers some of the top muni ETFs such as MLN for long-term municipal debt or SMB for short-term debt. One of the best ones is VTEB because it trades tax-exempt bonds and has a low 0.05% expense ratio.
If you're looking to invest in the best corporate, muni, and treasury bond ETFs, then Robinhood is a great place to start.
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Stocks
Robinhood is an easy-to-use platform for trading stocks, ETFs, options, and crypto. Investors can use their app to frictionlessly buy the top-performing ETFs. It's a great place to get your hands on a treasury bond ETF before interest rates rise even more.
If you're a pro trader and want to step up your game, then sign up for TradeStation. TradeStation is a trading platform that lets you buy stocks and ETFs as well as options, futures, and even bonds.
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This platform will help you cut out the middle man and buy treasury notes and investment grade bonds directly from the broker. With TradeStation's advanced analysis tools, all the market data you need to get the best investment results is at your fingertips