Categories
ETF investing Investing

How bond ETFs work

The ETF market has traditionally been dominated by equity ETFs. But bond ETFs are rapidly gaining traction [1]. Bond ETFs are the best option for retail investors to invest in bonds. How do bond ETFs work? What do you have to know before investing in bond ETFs? Let’s find out.

Before you begin…

Make sure you know the basics

To understand how bond ETFs work, you must first understand how bonds work. Are you comfortable with bonds? Do you understand concepts such as maturity, yield to maturity, interest rate risk and duration? This entry assumes so. In fact, you won’t benefit from this text if you’re not familiar with all concepts above. Good news is that they’re all covered in this other entry. Make sure you understand the basics of bonds before you continue reading.

Assess your current bond exposure

If you’re here, chances are that you want to buy bonds. That’s great! Investing is almost always a good financial decision. There’s something you should think about first, though. How high is your bond exposure already? If you think it’s 0, you might be miscounting. Have you thought, for example, of your pillar 2 portfolio? Or of any other pension fund if you don’t live in Switzerland? Your bond exposure is easier to underestimate than your equity exposure. Make sure you don’t.

The basics of bond ETFs

What are bond ETFs?

Bond ETFs are a type of ETF that invest solely in bonds [2]. Remember that ETFs are funds, or baskets of securities. So a bond ETF is a portfolio of bonds. A good thing about ETFs is that they trade on an exchange, the same way as a stock does. All in all, a bond ETF is a portfolio of bonds that you can buy in a centralized exchange.

Since when do bond ETFs exist?

Bonds ETFs are a new thing. At least relatively speaking. The first bond ETF saw the markets on July 26, 2002 [3]. For comparison, the first equity ETF came out in early 1993 [4].

Why do you need bond ETFs?

We saw in how bonds work that, unlike stocks, bonds don’t trade in centralized exchanges. Instead, bonds trade over-the-counter (OTC). As an investor, you don’t like OTC trading. It requires trading through dealers, which is out of reach most most retail investors, including you and me.

The main reason for you to invest in bond funds, such as bond ETFs, is that there’s no other viable alternative

With OTC trading out of the picture, we’re left with bond funds as the only alternative to invest in bonds. Bond ETFs are a subset of these funds. They’re typically the cheapest option, and you can trade them just like stocks.

Why bond ETFs are great

It may seem at first that we’re left with bond ETFs as our only suboptimal alternative to invest in bonds. However, this is far from the truth. Even if it was feasible for us retail investors to trade individual bonds, bond ETFs would still be a superior option. Why? Here are some reasons.

Liquidity

Bond ETFs trade on an exchange. An exchange provides centralization and accessibility. This makes it easy for investors to transact. And the more investors trading in a market, the higher the liquidity. As a result, the liquidity of bond ETFs is exceptional compared to individual bonds. In fact, bond ETFs are often more liquid than the underlying bonds in the fund themselves. Bond ETFs can even help solve illiquidity issues of the underlying bonds sometimes [5]. Higher liquidity also results into lower bid-ask spreads, which effectively means more efficient trading.

Simplicity

Just picture for a second what OTC trading would imply. You’d have to find the bond you want. In the quantity you need. And at the price you’re willing to pay. This is a nightmare. No single dealer would have everything you want. So you’d have to contact dozens of them. And find the time to negotiate with them. Buying a bond OTC would take a similar effort to buying a second hand car. Who’s up for that?

Bond ETFs, in contrast, are publicly listed. Just find public info on your ETF of choice, send an order to the exchange through your broker, and wait for it to fill. Dealers are cut out the equation for the benefit of everyone else.

Transparency

Imagine you’re trading OTC and come to the point of negotiating the price with a dealer. How do you know what’s the fair price of a bond? You’d have to value the bond yourself. Or get access to some sort of valuation model. And even then it wouldn’t be an easy discussion. Incentives aren’t aligned. Your win is the dealer’s loss, and vice-versa. And what if another dealer would sell the same thing cheaper?

Bond ETFs trading on an exchange translates into full transparency. Buyers and sellers can transact directly with each other. Prices of previous transactions are made available and constantly updated throughout the trading day. Investors (you) can use this information to make sure they’re trading at a price that the market considers fair.

Diversification

Same as equity ETFs, a single bond ETF can easily contain thousands of bonds. This ensures you don’t put all your eggs in one basket.

Funds don’t pool bonds at random. They normally have a target. For example, this can be a certain geographical exposure or a duration target. We’ve already made this point before, but imagine the pain of buying thousands of bonds from different dealers yourself.

Cost efficiency

Ditching the dealers is fantastic for cost efficiency. We already saw that the liquidity of bond ETFs translates into smaller bid-ask spreads. But there’s more. Because ETFs are basket of bonds, you pay transaction fees just once to transact hundreds or thousands of bonds.

The bonds in the fund are also automatically rotated for you. And in a very economical way. The TERs of the biggest five bond ETFs are 5, 4, 15, 5 and 9 bps [6]. For context, bid-ask spreads for OTC bonds are in the range of 0.5% to 5% [7]. Comparing TERs and bid-ask spreads isn’tt an apples-to-apples comparison. But you get the point.

Investing in individual bonds vs investing in bond ETFs

By now you should be convinced of the wonders of bond ETFs. It’s time to cover the differences between individual bonds and bond ETFs. Bond ETFs behave different from individual bonds in many aspects. The following are the key things to know.

The underlying bonds you hold keep changing

The most obvious difference between individual bonds and bond ETFs is that the latter is a basket of bonds. But there’s more to that. The basket you own is not fixed. It keeps changing. The fund continuously buys and sells bonds. Why do they do that? There’s two reasons. The first one is that bonds in the basket mature and have to be rotated. The second is to keep certain parameters (such as duration) in the desired range.

You receive interests every month

Bonds pay coupons. For a single bond, coupon payments usually take place either once or twice a year. Bond ETFs hold up to thousands of individual bonds. And their coupons are not necessarily synced. That means that there’s coupons flying into the fund all year round. Instead of paying out the coupons as they arrive, bond ETFs typically arrange a monthly payout schedule. This results in you receiving interests each month. Make sure you check your fund’s prospectus to get the specific details.

The price of a bond ETF doesn’t go up with time

This is not something you would expect with individual bonds either, but is still worth to clarify. We shouldn’t expect bond ETFs to go up in price the way equity ETFs do. There’s no intrinsic reason for it to happen. The price of a bond ETF fluctuates as interest rates swing. It goes up when rates decrease and vice-versa.

This isn’t a big deal. Remember that you don’t care that much about price return. You care about total return. And, for bonds, total return = price return + coupons. A price return of 0 is fine if you get all promised coupon payments.

Look for example at this chart of BND. BND is the second biggest bond ETF in the world at the time of writing [8]. The price of a share barely changed from 2007 to 2018. This means the price return is close to zero. Its total return isn’t. Why? Because of the monthly coupon payments (interest) it pays out. If you were to reinvest those, the total return would be even higher thanks to the compounding effect.

The yield to maturity is somehow hypothetical

All metrics of an ETF fund are an aggregation (weighted average) of those of the individual bonds in the fund. The yield to maturity (YTM) falls in this category as well. The YTM of the fund as a whole is the aggregation of the YTMs of all bonds in the fund. So far, so good.

Compared to individual bonds, however, the YTM of a bond ETF is a rather hypothetical figure. Why? Because of two reasons:

  • Bond ETFs often don’t hold bonds to maturity
  • The YTM of bond ETFs doesn’t include fund expenses (e.g. TER)

Bond ETFs never mature

This is probably the most shocking and difficult to grasp difference between individual bonds and bond ETFs. We saw in how bonds work that the time to maturity is a key characteristic of a bond. At maturity, investors get the face value of the bond. Unlike individual bonds, bond ETFs don’t mature. This fundamentally changes the nature of the investment. What are the implications for you as an investor?

  • The face value is gone: With bond ETFs, investors don’t get back the face value at maturity. Why? Well, because the fund has no maturity
  • Interest rate risk is critical: Because bond ETFs don’t mature, the only way for your bond investment to terminate is by selling your shares. The selling price will be different from the price at which you bought. Why? Because interest rates fluctuate. And you know that interest rate changes cause changes in bond prices
  • Pragmatically, duration is ‘the new maturity‘: The previous point on interest rate risks should raise a red flag. Are we left at the mercy of interest rates? No. Not completely, better said. An old friend is coming to the rescue. Remember the concept of duration? If you don’t, go back here. Duration is the key metric for you to manage the interest rate risks of a bond ETF

How interest rates affect total return in a bond ETF

The right questions

Bond ETFs never maturing is a big deal. What happens to your investment if interest rate rise? When investing in an individual bond, we know that a increase in rates must mean a decrease in price. But with individual bonds, we also know that if we hold the bond until maturity we get the YTM as the annualized return. Since bond ETFs don’t mature, how are we protected from rising yields? How can we mitigate interest rate risks?

The answers to these questions are often difficult for retail investors to grasp. We’ll try to clarify all of them through a practical case. The example is largely based on this entry.

A practical example

Let’s consider again the bond ETF BND. We’ll pick a historical data point from July 2018. Back then, the YTM of BND was 3.12%. And it had a duration of 6.1 years. Imagine you had invested in BND and yields had increased the day after. What would have happened to your annualized total return? The table has the answer.

Initial YTM: 3.12%
Duration: 6.1 years

Change in yield (p.p.)Year 1Year 2Year 3Year 4Year 5Year 6Year 7Year 8Year 9Year 10
+0%3.12%3.12%3.12%3.12%3.12%3.12%3.12%3.12%3.12%3.12%
+1%-2.48%0.77%1.87%2.43%2.77%2.99%3.15%3.27%3.37%3.44%
+2%-8.08%-1.70%0.52%1.65%2.34%2.80%3.12%3.37%3.56%3.72%
+3%-13.68%-4.29%-0.94%0.78%1.83%2.53%3.04%3.42%3.71%3.95%
+4%-19.28%-7.01%-2.52%-0.2%1.23%2.19%2.88%3.40%3.80%4.13%
+5%-24.88%-9.88%-4.24%-1.29%0.53%1.75%2.64%3.31%3.83%4.25%

Source: Vanguard, accessed through etf.com

Rows in the table are changes in YTM, in percentage points, immediately after buying. For example, a change in YTM of 1% would mean that yields rose from 3.12% to 4.12%. The different columns are the annualized total returns (the CAGR) after a number of years. Numbers in red are negative total returns. Numbers in orange are positive total returns below the original 3.12%.

Let’s focus on a particular example. Say yields rose by 2% to 5.12% immediately after buing. What would have happened?

  • The initial price shock is quite big. Total return after year 1 is -8%!
  • As time goes by, annualized total returns stabilize. They become positive by year 3
  • After 7 years, the annualized total return is back to the original 3.12%.
  • Past 7 years, the annualized total return exceeds the original 3.12%

Lesson learned: duration is the key

Notice how, in our example, the annualized total return goes back to the original 3.12% after a period of time close to the duration.

This generalizes well for small changes in interest rates. For changes in interest rates of up to 3%, after 6-7 years the annualized total return goes back to roughly 3.12%, the initial YTM. For bigger changes in interest rates, this approximation starts to become less accurate. But still gives a very good indication.

As a rule of thumb, any change in annualized returns of a bond ETF caused by a change in interest rates is offset after a period of time roughly equal to the duration of the fund

The highlight above is the most importance sentence in this whole entry. Read it twice.

Why do annualized returns stabilize over time?

When yields rise, the price of bonds fall. So it makes sense that the price of a bond ETF falls along. But why does the annualized total return go up as time goes by? We saw a hint on the answer in how bonds work: we can reinvest at higher rates.

Let’s look at it pragmatically. The bonds in a bond ETF change over time. In our example, Vanguard continuously buys and sells bonds. Either because bonds are maturing or simply to keep the duration of the portfolio within the desired range. When yields rose by 2%, the ETF price took a hit. But new bonds yielding 5.12% became available. 5.12% is higher than our original yield of 3.12%. Over time, the higher yield of new bonds offsets the initial value loss. And it can even lead to better results if you hold for long enough.

If you reinvest all coupons received at the higher YTM, the recovery process would be even faster.

A word of inflation

In reality, if yields rise it’s likely that inflation expectations went up. Your real returns might take a hit even if your nominal returns stabilize or even slightly increase. More on nominal vs real returns here.

Timing is still important

In our example, we fought an initial rise in yields by holding the ETF for a period of time around as long as its duration. We simply had to wait long enough for the annualized total return to stabilize. But what if yields hadn’t changed at the beginning? Imagine your investment horizon is 6 years, and yields sharply increase in year 4. What could you do? Well, there’s only two options:

  • Stick to your original investment horizon and realize lower-than-expected returns
  • Increase your investment horizon to offset or even benefit from higher yields

No solution is perfect. This is why interest rate risks are so important in bond ETFs. You’ll always be exposed to them.

How much should we expect interest rates to change?

Nobody knows. Whoever tells you anything different is being overly confident on their predictions. Which furthermore are likely wrong.

The only thing we can do is look at the past to get a sense of how much rates have fluctuated historically.

Data from SNB

The chart contains the policy rates for many developed markets. ECB stands for European Central Bank. SNB for Swiss National Bank. The Fed is the US equivalent. Central banks update policy rates to influence the economy. Policy rates affect all other interest rates, including bond yields.

In general, central banks lower policy rates to make borrowing easy and stimulate the economy in periods of need. For example, during a recession. During good times they typically move them back up to control inflation and reload their weapons.

From the chart we can conclude that:

  • We are in a period of low interest rates. However, this doesn’t necessarily mean that rates will go up anytime soon
  • Absolute changes of more than 1% per year aren’t rare

What you’ve learned

Hats off if you’ve made it here. This entry is long, dense, and conveys complex concepts. Bond ETFs are not an easy topic, and you might not remember everything you’ve read. Still, I hope you take with you the following main takeaways:

  • Bond ETFs are the only accessible option for retail investors to gain bond exposure. They have several advantages over individual bonds
  • Bond ETFs behave differently than individual bonds. The most important different is that bond ETFs never mature
  • Because bond ETFs don’t mature, interest rate risks become critical. Duration is a key metric for you to manage the interest rate risks of a bond ETF

Leave a Reply

Your email address will not be published. Required fields are marked *