Fixed-Income (Bond) ETFs

Bonds are loans that investors make to corporations and governments. They are also known as fixed-income investments because the corporation or government that issues a bond typically pays the bond investor a fixed amount of interest income over a set term, or period of time. At the end of the term, the investor also gets back the original investment amount, called the principal. All bonds have a face value (the price of the bond), and a coupon, which is the annual rate of the interest that the bond pays the investor. For instance, an investor who buys a bond with a face value of $1,000 and a coupon of 5% will pay $1,000 for the bond and receive $50 in interest payments each year.

Bond ETFs track indexes that contain individual bonds. Bond ETFs don’t have a face value or a coupon rate, however. Instead, bond ETFs have a share price that’s determined by the prices (face values) of the individual bonds in the index that the ETF tracks—when the prices of those bonds rise, the ETFs share price also rises. In place of a coupon rate, bond ETFs have a yield (interest payment) that equals the average interest rate of the bonds in the index that the ETF tracks. Though the interest payment on an individual bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF shift. Generally, these interest rates change only in small degrees.

Investors buy bonds in order to build portfolios that suit their ideal asset allocation. Bonds tend to have a low correlation with stocks—that is, when stocks fall, bonds tend to rise. Therefore, owning bonds can help provide a “safety cushion” in the event of a downturn in the stock market. In addition, bonds provide a steady stream of income at rates considerably higher than the average dividend yield of stocks—about 5% annually for bonds compared to just 1.5% or so for stocks.

Investors by bond ETFs for the same reason they buy bond mutual funds—to avoid the hassle and expense of buying a collection of individual bonds. Though bond ETFs tend to have lower expense ratios than most bond mutual funds, there are currently only a few bond ETFs, whereas there are hundreds of bond mutual funds. Nonetheless, there are a number of options for bond ETF investors who want exposure to the overall bond market conveniently and at a low cost.

Barclay’s iShares, the leading provider of ETFs, currently dominates the bond ETF market. iShares offers a varied selection of different bond ETFs, each of which tracks the performance of a specific index of bonds classified by term and/or issuer.

Every bond has a term that begins with its date of issue and ends with its maturity date—the specific date on which the company or government that issued the bond redeems, or recalls, the bond and stops paying interest on it. The bond ETFs that are currently available track indexes with bonds that have terms that all fall within a certain range, such as 1–3 years or 7–10 years. Longer-term bonds—and the bond ETFs that track indexes of them—tend to have higher yields than shorter-term bonds.

A bond’s issuer is the company or government that issues the bond. The bond ETFs that are currently available track indexes of bonds issued by governments or corporations.

Most bond ETFs track indexes of bonds that have a specific term and issuer. For instance, a 7- to 10-year Treasury bond ETF will track an index of bonds issued by the U.S. government with terms of 7–10 years.

The final ETF in this table tracks an index of Treasury Inflation Protected Securities (TIPS). These bonds have low yields relative to other Treasuries but include a special feature: their yield adjusts annually based on the overall inflation rate. For instance, if inflation is 4%, the yield on TIPS will be at least slightly higher than 4% that year.

Currently, only a few ETFs track indexes that contain corporate bonds. The first two ETFs in the table below (CSJ and CIU) track a mix of government and corporate bonds, while the third (LQD) contains just corporate bonds.

Most niche bond ETFs are probably too specific for the average investor’s needs. Rather than buy several niche funds, it’s simpler to buy a broader bond ETF such as the iShares Lehman Aggregate Bond Fund® (symbol: AGG), which tracks a broad index of nearly all types of bonds.