Bond ETFs: the Ins and Outs

Investors are increasingly attracted to the affordability of these products.

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Bond exchange-traded funds are gaining momentum: Assets invested in this slice of the ETF market rose from $53 billion in mid-September 2008 to $91 billion this September, or 59 percent, according to TrimTabs Investment Research. What's more, the sheer number of bond ETFs has increased more than tenfold, from just six funds in 2006 to 67 in early September. "Although they don't get as much attention as equity ETFs, [bond ETFs] have really come on strong lately with more ETF providers," says Tom Lydon, editor of the blog ETF Trends. Another force driving the popularity of bond ETFs: Investors, looking for more diversification after suffering steep losses in 2008, are moving into more asset classes within the bond market, says James Ross, senior managing director of State Street Global Advisors.

Here are a few things to know about bond ETFs:

[See 9 ETFs For 2009 and Beyond.]

A Departure From Index Funds. Exchange-traded funds are very similar to index mutual funds in that they generally mirror an index, such as the S&P 500 or the Russell 2000. But unlike mutual funds, they can be traded throughout the day. "Having interday liquidity is an advantage to some investors and even mutual fund managers themselves," says Lydon. "More mutual fund managers and investors are putting money into ETFs so they can have instant allocation in areas they are looking for."

[Also see the Case Against (Some) ETFs.]

ETFs also are more tax efficient than mutual funds, says Scott Burns, Morningstar's director of ETF analysis. And the annual fees of ETFs generally are much lower. That's because most ETFs are passively managed. "A fixed-income ETF is going to be the better vehicle if you want to index the bond market," says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors. "If you have a fairly large sum investment, ETFs are great because the long-term costs are lower."

Drawbacks. Even though ETFs tend to be cheaper, frequent trades can be costly. "If you are putting a little money in every month, a fixed-income ETF won't be an economical solution because brokerage costs are going to eat up your advantage," says Wiener. Fees on ETFs can add up because investors trade them through brokerages, which often charge for each transaction. However, if an investor makes a large, long-term investment, Wiener says, "any disadvantage in price will probably go away if the investor holds it for a little while."

For bonds overall, investors face the risk of rising interest rates and inflation. "The big fear right now is that we're in a situation where interest rates have remained at historically low levels and fixed-income markets have stabilized," says Lydon. "In the near future, we're going to see higher interest rates, maybe because of inflation or rising debt, and if we do, the value of bonds will decline." He says that there is a greater risk with bond ETFs because their underlying holdings may not be held to maturity and thus the underlying value may decline if interest rates go up.

Timely Investment. "You're seeing a broad take-up of bond ETFs in reaction to the global economic market," says Ross. He says that before the 2008 recession hit, investors were generally incorporating just one broad-based bond fund into their portfolio. Nowadays, investors are looking for more diversification among investments, including bonds. "It's been a pretty large trend from our business perspective and from the industry perspective to invest in bond ETFs," Ross says.

Another reason bond ETFs are taking off: As the baby boomers retire, they're increasingly turning to bonds for income, says Lydon. Depending on an investor's personal goals, Ross suggests investing in lower-risk, and therefore lower-yield bond ETFs, such as TIPS (Treasury Inflation-Protected Securities) funds. He also advises investing a small amount in corporate and municipal bond ETFs. In addition to high-yield corporate bonds, the largest bond ETF investments made this year have been in international TIPS and municipal bonds, according to Ross.

Companies are expanding their bond ETF offerings. "The fixed-income slice of ETFs were once the undeveloped parts of ETF universe, and now companies see an opportunity to expand their fixed-income ETF offerings," Burns says. Vanguard offers five bond ETFs, which have been available since 2007. The firm is planning to launch seven more bond ETFs by the end of this year, including several corporate and government bond funds and a mortgage-backed securities fund. Pimco, the largest bond-fund manager, moved into the bond ETF market this year. In June, the firm rolled out its first ETF, a short-term treasury index fund. Since then, it has added four more ETFs, including several TIPS index funds. Pimco has also filed to open eight more bond ETFs—three treasury index funds and five actively managed bond funds. IShares, the largest provider of bond ETFs and the first company to offer them, has 25 bond ETFs. State Street Global Advisors, the second-largest bond ETF provider, counts 18 bond ETFs among its roster of funds.

Here are the five bond ETFs with the largest asset inflows from Jan. 1 to Sept. 16, 2009:

iShares Barclays TIPS Bond (TIP) $6,601,315,000
iShares iBoxx $ Investment Grade Corporate Bond (LQD) $5,319,490,000
iShares Barclays 1-3 Year Credit Bond  (CSJ) $2,594,390,000
Vanguard Total Bond Market ETF (BND) $2,174,404,000
iShares iBoxx $ High Yield Corporate Bond (HYG) $1,716,495,000

Source: TrimTabs Investment Research