Many people are looking at bond exchange-traded funds (ETFs) as an alternative to mutual funds these days.
There’s been a significant shift, with nearly $344 billion invested in bond ETFs through the end of October, compared to just $138 billion in fixed income mutual funds, according to data from Morningstar Direct. This shift is part of a larger trend where ETFs are gaining popularity, evidenced by around $74 billion leaving mutual funds and $166 billion moving into ETFs just in October.
While there are definite perks to investing in ETFs over mutual funds, and bonds are generally seen as safer than stocks, it’s crucial to understand what you’re getting into.
“Remember what role bonds play in your portfolio,” advised Dan Sotiroff, a senior analyst at Morningstar focusing on passive strategies. “Usually, they provide stability, but how much you allocate is something you’ll have to decide, possibly with an advisor.”
“Legitimate Edge”
Both mutual funds and ETFs pool together various investments. ETFs offer several advantages, including lower costs, tax efficiency, and the ability to trade throughout the day. In contrast, mutual funds only get priced once per day after the market closes at 4:00 PM ET.
The rising interest in bond ETFs may be tied to the fact that actively managed ETFs are gaining traction. This means professionals are making investment choices, which wasn’t the case with bond mutual funds until recently. On the flip side, passively managed ETFs simply mimic an index’s performance.
“There are clear benefits to active management,” Sotiroff noted. “Managers can bring something innovative to the table and aim for better returns than the benchmark.”
Currently, there are 511 actively managed bond ETFs, surpassing the 393 passively managed ones, according to Morningstar.
However, active funds come with higher fees. Typically, investors pay an average of 0.35% for actively managed bond ETFs, compared to 0.10% for the passive options.
Be Aware of What Bonds You’re Buying
Since bonds pay out interest, ETFs distribute monthly payments to investors, who may face tax implications depending on their account type. If held in a taxable brokerage account, that income is subject to taxes, but if it’s in an IRA or 401(k), it grows tax-deferred. Withdrawals from a Roth IRA are tax-free.
When choosing between passive or active bond ETFs, it’s important to consider the bond types involved. For example, U.S. Treasuries and certain corporate bonds are categorized as investment-grade, representing a lower risk of default.
“Keep in mind that the correlation with stocks is quite low, which is essential for diversification,” Sotiroff pointed out.
Investment-grade bonds typically offer lower returns than riskier bonds. Those high-yield corporate bonds may have attractive yields, but they also come with a greater risk of default.
If you’re depending on bonds for retirement income, trying to extract too much income might backfire.
Tim Videnka, a certified financial planner and chief investment officer at Forza Wealth Management, stressed that bond ETFs “need to be both liquid and high-quality, as they essentially fund your living expenses.”
Bonds Can Also Lead to Losses
Of course, bonds aren’t without risks, as Videnka noted. “They can definitely lose value.” In 2022, rising interest rates set by the Federal Reserve to combat inflation resulted in falling bond prices, marking that year as one of the worst for bonds.
In fact, the bond market took a hit, showcasing that losses can happen even here. “People often forget the potential for loss when panic strikes,” he added.
When interest rates rise, newly issued bonds come with higher rates. This makes existing bonds less valuable, thus lowering their prices. While the Fed cut its benchmark interest rate again in October, it remains higher than it was in previous years.
“Looking back to 2008-2009 during the financial crisis, we were in a 0% environment, and then the pandemic hit, bringing us back to that same situation,” Sotiroff recalled. “Now, interest rates are actually positive, and bond ETFs can offer appealing returns.”
