Fixed Income Part 2: Bond ETFs

In my last post I discussed the pros and cons of bonds. One limitation to bonds is that the usually require an investment of over $1,000, and sometimes over $5,000, to purchase, which may not be a viable option for the casual investor. One alternative to purchasing de-facto bonds is bond ETFs.

Pros

There are several bond ETFs on the market from the major ETF players such as iShares and Bank of Montreal, covering a wide range of requirements, such as government bonds, corporate bonds, real return bonds, etc. In terms of accessibility, ETFs trade on most major exchanges, and as such they are easily accessible to anyone with a trading account. Bond ETFs are also attractively priced, which puts them within grasp of those with minimal funds to invest; a small position can be created with as little as $100, a far cry from the $1,000 minimum investment for most bonds. Yields are comparable to the bonds that underlie the security, so even a small position would have a net positive payout over time.

Another advantage to bond ETFs is that they offer a good degree of diversification. A bond ETF is composed of a number of underlying bonds, the exact bonds being dictated by the investment objectives of the ETF. For example, as of August 26, the BMO Long Federal Bond Index ETF holds 11 different bonds:

Security %
Cda Govt 5.00 01Jun37 0.1893
Cda Govt 4.00 01Jun41 0.1885
Cda Govt 5.75 01Jun29 0.1847
Cda Govt 5.75 01Jun33 0.178
Cda Govt 3.50 01Dec45 0.0602
Canada Post 4.08 16Jul25 0.0549
Cda Govt 8.00 01Jun27 0.0508
Cda Govt 8.00 01Jun23 0.0333
Cda Govt 9.00 01Jun25 0.0276
Cda Govt 1.5 1Jun23 0.0238
Canada Post 4.36 16Jul40 0.0108

By purchasing a single ETF, you now hold portions of 11 bonds, greatly diversifying the risk of holding a single bond.

Cons

The biggest challenge with bond ETFs doesn’t come from the bond ETF per se, but from the structure of ETFs in general. In its simplest form, an ETF, or exchange traded fund, is a collection of underlying securities which are wrapped up as an ETF, and traded on the open market. ETFs are similar to their mutual fund brethren, two of the key differences being that ETFs trade on major exchanges, and that the key fees inherent in mutual funds (such as front load or back-end load) are represented by standard brokerage fees for trading on the exchange.

Bond ETFs being composed of the underlying bonds is the major challenge. Bonds are directly impacted by interest rates: as interest rates rise, bond prices fall, and vice-versa. Because an ETF is made up of a collection of underlying bonds, as the value of the underlying bonds rises (or falls), the ETF itself rises (or) falls in value. In a period of falling interest rates this means that the underlying bonds rise in value, with a corresponding rise in the value of the bond ETF. Interest rates are currently at historical lows, which means that over time interest rates have nowhere to go but up. As interest rates rise, the underlying value of the bonds will fall, which means bond ETF prices will fall as well.

Why does this matter? Ignoring the obvious fact that your initial investment will fall as interest rates rise, you also suffer from a loss of capital. If you buy a $1,000 par bond today, which matures in 5 years, you are guaranteed two things:

  • The coupon payments of the bond over the next five years
  • The $1,000 principal in the fifth year

However, with a bond ETF, you are not guaranteed your principal since the bond ETF never matures. If you take the identical $1,000 investment for the $1,000 bond and purchase $1,000 worth of shares of a bond ETF, if the rates fall and you sell your ETF shares, you will receive less than your initial investment.

One final drawback to a bond ETF is with regards to the “coupon” payments. Any distributions from the underlying bonds, after paying management fees (defined as the MER) should be distributed to the shareholders. However, because the ETF is composed of a number of underlying bonds, those distributions may change over time. In terms of predictable cash flow, a bond ETF may not be the best option. Looking back to the $1,000 bond example above, if the bond pays a 5% coupon on a $1,000 semi-annually, I am guaranteed $25.00 every six months. This relationship may not hold for an ETF since the underlying bonds of the ETF may change over time.

Wrapping it all up

In terms of accessibility, bond ETFs cannot be beat. They offer low initial investment costs, and offer great diversification. However, since they do not have maturity dates as with a typical bond, you risk losing portions of your initial investment as interest rates rise. Of course, the opposite is also true: if interest rates fall, your initial investment will appreciate. As also mentioned, the cash flows may not be consistent while you hold the ETF (although they may fall or rise, depending on the underlying bonds). However, given that interest rates are already fairly depressed, the likely direction of interest rates in the future is up, not down.

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