One thing I’m learning is that there is still a lot of confusion when it comes to fixed income and fixed income ETFs. With a size of more than $36 trillion the US fixed income market is significantly larger than the US stock market, but it still seems to mystify many investors.
In December, Sue wrote a blog about getting back to ETF basics, and I thought it would be helpful to write a similar blog about fixed income ETF basics.
For starters, fixed income is a highly diverse asset class that can include Treasury bonds, foreign bonds, municipal bonds and inflation-protected securities. Investors can use fixed income products to help them generate income; to manage risk as bonds generally generate less risk (and return) than stocks; and anchor a diversified portfolio because bond returns generally have a low or negative correlation to riskier asset classes like stocks.
Fixed income ETFs are funds that are designed to track an index and they generally hold a large number of bonds (like a mutual fund does), but they trade on an exchange like stocks. Let’s break down these concepts.
Tracking an Index
Bond market indices are created and maintained by index providers such as Barclays Capital or Markit iBoxx. Index providers publish a set of rules and all of the bonds that meet those rules are included in the index. These indexes can be designed to track the performance of either the overall bond market or a specific sector of the market – like government bonds or municipal bonds.
ETFs are then designed to track the performance of a specific bond market index, which allows investors to use fixed income ETFs to achieve broad or targeted bond market exposure. For instance the iShares Barclays Aggregate Bond Fund, AGG, seeks to track the Barclays Capital U.S. Aggregate Bond Index, which gives investors access to the US investment grade bond market. But investors seeking to access the muni bond market might be more interested in the iShares S&P National AMT-Free Municipal Bond Fund, MUB, which seeks to track the S&P National AMT-Free Municipal Bond Index.
I’ve written a blog on bond indexes and how they are put together that you can read here.
Trading like a Stock
Bonds are bought and sold “over-the-counter” where buyers and sellers negotiate one-on-one to reach a deal. That means it can be hard for investors to track down individual prices of bonds (You can hear about my attempt to do so in this video). But fixed income ETFs trade on an exchange similar to individual stocks. Just as you can buy or sell shares of Google or GE throughout the trading day, so too can you buy and sell shares of fixed income ETFs. Just as you can check in daily on the price of those stocks, so too can you check in daily on the price of your fixed income ETF. (We’ll cover this topic more in-depth in a future blog post)
You can also watch this video, where I explain how index fixed income funds are managed. And if you have any more questions let me know, I am always looking for ideas on what to write about.
Bonds and bond funds will decrease in value as interest rates rise. Diversification may not protect against market risk.
When comparing bonds and ETFs, it should be remembered that management fees associated with fund investments, like ETFs, are not borne by investors in individual bonds.
Shares of ETFs may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units.