Bond Funds Vs. Etfs: Where Should You Invest?

Investing in bonds can be a great way to generate income, but how do you go about it? Two of the most popular options are bond funds and bond ETFs. Bond funds are mutual funds that pool capital from investors, which is then allocated to various fixed-income securities by a fund manager. Bond ETFs, on the other hand, track an index of bonds and aim to match the returns of that index. So, which is the better option for you?

Bond funds vs bond ETFs: What's the difference?

Bond funds and bond ETFs are two investment options that pool funds into a diversified, fixed-income portfolio. However, there are some key differences in how each operates.

Bond funds are mutual funds that pool capital from investors, which a fund manager then allocates to various fixed-income securities. They are actively managed and can be bought directly from fund providers, meaning they don't need to be purchased through a brokerage account. They are priced and traded once a day, after the market closes, and their trading price is a direct reflection of the net asset value (NAV). Bond funds may also charge an extra fee if they are sold prior to a certain minimum holding period. They do not reveal their underlying holdings on a daily basis, making it difficult for investors to determine the precise composition of their portfolios.

Bond ETFs, on the other hand, track an index of bonds designed to match the returns from the underlying index. They are traded on exchanges throughout the trading day, offering real-time pricing and the ability to respond swiftly to market changes. They are purchased through a brokerage account and must be traded on the open market. The prices for shares can fluctuate moment by moment and may be higher or lower than the net asset value of the underlying securities. Bond ETFs usually disclose their underlying holdings daily, giving investors complete transparency.

Both bond funds and bond ETFs can pay dividends and offer a wide variety of investment choices. They can also be purchased and sold through a brokerage account for a small per-trade fee.

When deciding between the two, consider your investment objective. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs are a good choice. For long-term, buy-and-hold investors, both options can meet your needs, but be sure to research the holdings in each fund.

Bond Funds vs Bond ETFs: The Pros and Cons

Bond Funds: The Pros

• Professional management: Bond funds are run by professional portfolio managers who specialise in certain bond sectors or strategies.
• Diversification: Investing in bonds and other debt securities may help lower the overall risk of your portfolio.
• Liquidity: Bond mutual funds tend to be liquid as they can be bought and sold at the closing net asset value (NAV) each day.
• Low investment minimums: Some bond mutual funds can have minimums as low as $1.
• Automatic investing: Some providers allow investors to automatically invest a fixed-dollar amount on a regular basis.
• Reinvestment of dividends and capital gains: Investors who don't need the income have the option to automatically reinvest interest and capital gains back into the fund.

Bond Funds: The Cons

• Trading limitations: Bond mutual funds only trade once a day, after the market closes, so you won't know the exact price when you place your order.
• Limited transparency: Mutual funds generally only disclose their portfolio holdings quarterly.
• Lack of customization: Bond funds are managed according to stated objectives and cannot be customised.
• Potential tax inefficiency: Bond funds may not be tax-efficient since they usually distribute capital gains to investors.
• Lack of control: The bond fund manager determines the timing of buys and sells, and at times may be forced to sell positions to meet liquidations.

Bond ETFs: The Pros

• Diversification: Bond ETFs can help mitigate the impact to the investor if the bonds from a single issuer fall in value or default.
• Tax efficiency: ETFs often generate fewer capital gains for investors since they may have lower turnover.
• Transparency: Holdings are generally disclosed daily, so investors know exactly what securities the ETFs hold.
• Flexibility: Bond ETFs trade throughout the day and can use limit and stop-limit orders.
• Lower expenses: Bond ETFs typically have lower operating expense ratios (OERs) than bond mutual funds, especially actively managed funds.

Bond ETFs: The Cons

• Price to net asset value: The market price of a bond ETF could vary from the net asset value (NAV) of the underlying securities.
• General liquidity: The liquidity of a bond ETF depends on the number of market makers interested in buying or selling at a given point in time.
• Potential low returns: In a low-interest-rate environment, yields are likely to reflect the broader market.
• No guarantees of principal: There are no guarantees on your principal when investing in the market.

The pros and cons of bond ETFs

The Pros of Bond ETFs:

Bond ETFs, or exchange-traded funds, are a welcome addition to investors' portfolios. They are highly versatile and can be used for speculation, income, or protection. They are also beneficial because:

• They are easier to manage. Bond ETFs pay out the interest they receive on the bonds in their portfolio, providing a good way to set up an income stream without worrying about the maturity and redemption of individual bonds.
• They pay monthly dividends, giving investors regular income on a short timeframe.
• They provide immediate diversification, both across a portfolio and within the bond portion of a portfolio.
• They offer targeted exposure to bonds. Investors can select the segment of the market they want to own, such as intermediate-term investment-grade bonds or high-yield bonds.
• There is no need to analyze individual bonds. Investors can select the kinds of bonds they want and then use the ETF they want.
• They are generally cheaper than buying bonds directly. By buying a bond ETF, investors leverage the fund company's ability to get better pricing on bond purchases, reducing their expenses.
• They are more accessible to individual investors. Bond ETFs are traded on the stock market like stocks, and investors can move in and out of positions easily.
• They are tax-efficient, generally passing on few, if any, capital gains to investors.

The Cons of Bond ETFs:

• Expense ratios may be relatively high. A bond fund's expenses may eat up a sizable portion of the interest generated by the holdings, reducing the yield.
• There is a potential for low returns, especially when interest rates are low.
• There are no guarantees of principal. Investing in the market is risky, and if interest rates turn against you, the wrong kind of bond fund may decline a lot.

Bond ETFs vs. bond mutual funds

Bond mutual funds and bond ETFs (exchange-traded funds) are similar in that they both feature a basket of bonds or other debt instruments. However, there are some key differences to note.

How They Work

Bond mutual funds pool capital from investors, which a fund manager then allocates to various fixed-income securities. Bond ETFs, on the other hand, track an index of bonds, aiming to match the returns of the underlying index. Bond mutual funds are actively managed, while bond ETFs are typically passively managed.

Fees and Expenses

Bond mutual funds generally have higher expense ratios due to active management and other fees. Bond ETFs, in contrast, tend to have lower expense ratios, making them more cost-efficient.

Buying and Selling

Bond mutual funds are bought and sold at the end of the trading day at the net asset value (NAV). Bond ETFs, however, can be traded throughout the day on stock exchanges at market prices, which can fluctuate.

Minimum Investment

Bond mutual funds often have a minimum investment requirement, while bond ETFs can usually be purchased with a single share, making them more accessible to investors with less capital.

Transparency

Bond mutual funds disclose their holdings on a monthly or quarterly basis. Bond ETFs, on the other hand, offer greater transparency by disclosing their holdings daily.

Suitability

Bond mutual funds are suitable for investors seeking professional management and specific investment strategies. Bond ETFs, meanwhile, are a good fit for those seeking cost efficiency and ease of trading.

Historical Performance

Bond mutual funds have been investing in bonds for many years, with some of the oldest balanced funds dating back to the late 1920s. Bond ETFs, on the other hand, are a newer entrant to the market, with the first bond ETF launched in 2002.

Tax Efficiency

Bond mutual funds are less tax-efficient than bond ETFs due to frequent buying and selling by the manager, potentially leading to capital gains distributions. Bond ETFs, especially those that track an index, are more tax-efficient due to lower turnover.

How to generate income with bond ETFs

Bond ETFs are a great way to generate income, offering a low-cost, diversified, and flexible investment option. Here are some key ways to generate income using bond ETFs:

• Income through regular coupon payments: One of the main advantages of bond investments is the regular income they provide. Most bonds make periodic interest or coupon payments, and bond ETFs pass on this income to investors through monthly dividends. The value of these coupon payments varies from month to month, as bond ETFs hold assets with different maturity dates and coupon schedules.
• Capitalising on higher interest rates: When the Federal Reserve raises interest rates, it can create opportunities for higher yields on bond investments. For example, after the Fed raised interest rates in 2022-2023, short-term Treasury bond yields increased to around 4%. Investing in bond ETFs at this time can allow you to lock in these higher yields and generate higher income.
• Diversification and reduced risk: Bond ETFs provide instant diversification across different types of bonds and maturities, which can help reduce overall risk in your portfolio. By investing in a range of bond ETFs, such as short-term, intermediate-term, and long-term funds, you can lower the volatility of your portfolio and protect yourself from significant losses if equity markets underperform.
• Access to a range of bond types: Bond ETFs provide access to various bond categories, including Treasury bonds, corporate bonds, junk bonds, international bonds, and floating-rate bonds. This allows you to choose the types of bonds that align with your risk tolerance and income goals.
• Low costs and tax efficiency: Bond ETFs generally have lower expense ratios than bond mutual funds, making them a more cost-effective option. Additionally, the ETF structure is tax-efficient, as they typically pass on minimal capital gains to investors, and any dividends are treated as income or capital gains for tax purposes.
• Liquidity and tradability: Bond ETFs are highly liquid, meaning they can be easily bought and sold on a stock exchange throughout the trading day. This flexibility allows you to respond swiftly to market changes and provides access to bond investments that might otherwise be challenging to purchase individually due to lack of liquidity.
• Instant portfolio diversification: With a bond ETF, you gain exposure to a basket of bonds with a single investment. This provides immediate diversification to your portfolio, reducing risk and allowing you to access a range of bond maturities and types without needing a large amount of capital.

When investing in bond ETFs, it's important to consider factors such as duration (interest rate sensitivity), credit quality, and geography. Additionally, remember to assess the expense ratios and management fees to ensure you're maximising your income potential.

The tax advantages of bond ETFs

Bond ETFs offer several tax advantages over other types of investments. Firstly, they are generally more tax-efficient than mutual funds due to lower turnover, meaning investors can benefit from lower capital gains taxes. This is because bond ETFs typically track an index of bonds rather than being actively managed, resulting in less frequent buying and selling, and thus lower capital gains distributions.

Secondly, the ETF structure is tax-efficient as it passes on few, if any, capital gains to investors. This is in contrast to mutual funds, which may pay out capital gains distributions at the end of the year, creating a capital gains tax liability even if the investor did not sell the fund.

Thirdly, bond ETFs offer tax advantages through their pricing structure. The quoted market price of a bond ETF is typically displayed as the midpoint of the bid and ask prices of the underlying securities. While the end-of-day net asset value (NAV) of an equity ETF is based on the closing prices of these securities, a bond ETF's NAV is struck using the bid-side pricing, which is generally lower. As a result, bond ETFs typically close at a premium, and this premium can help mitigate the risk of a "baked-in" loss upon sale.

Additionally, bond ETFs can provide tax advantages through their ability to maintain a specific maturity over time. This means that portfolio managers buy and sell bonds to ensure effective tracking, which can lead to capital gains. While these capital gains may be passed on to investors, the tax consequences can be minimised by holding bond ETFs in certain types of accounts, such as tax-advantaged retirement accounts.

Finally, bond ETFs offer improved tax efficiency compared to owning individual bonds due to their structure and the way they are traded on stock exchanges. This increased tax efficiency, along with their other benefits such as lower costs, flexibility, and diversification, makes bond ETFs a compelling investment option.

Frequently asked questions