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Why Invest in Bond ETFs

The bond exchange traded fund (ETF) market has grown to 577 funds, giving investors a broad selection of exposures that has helped create a more centralized and transparent fixed income marketplace.¹

August 14, 2023

Benefits of Bond ETFs

ETFs’ unique characteristics enable investors to:

Lower Costs Fees for US-listed bond ETFs are 60% lower than their mutual fund peers. US-listed fixed income ETFs have a median expense ratio of 0.28%, versus mutual funds’ 0.70%.² While many ETFs are index based, this lower-cost profile carries over to actively managed ETFs that have a median expense ratio of 0.40%, versus 0.71% for active mutual funds.³

ETFs offer structural advantages, compared to a single security or individual bond exposure. With individual bonds, broker-dealers collect commissions on bonds they sell or buy through markups and markdowns, which are bundled into the quoted price to investors on both sides of the transaction.

When an investor buys a bond, the dealer marks up the price of the bond above its face value. When an investor sells, the dealer will mark down the price of the bond and pay less than its current value. These transaction costs usually range from 1%–5% of the bond’s original value; however, they vary based on order size, issue or broker. Regulations now require bond dealers to publish their markups and markdowns on certain types of bonds on trade confirmations, which means after the transaction occurs.

Improve Liquidity ETFs' robust secondary market allows investors to tap into market liquidity more easily than they can with single-CUSIP bond holdings. This enables them to reallocate portfolios quickly across asset classes or meet investor redemptions by selling an ETF position into the market without having to sell single-CUSIP bonds. Fixed income ETFs are also more liquid than mutual funds, as ETFs trade intraday and mutual funds are typically transacted end of day.

Increase Transparency Both index-based and actively managed ETFs report holdings daily, increasing transparency for investors performing daily portfolio due diligence and attribution for risk management.

Mutual funds report their holdings less frequently — typically, quarterly. That means any allocation changes in a bond mutual fund could take place months before shareholders are aware of them.

Target Duration ETFs precisely cover the entire term structure along the yield curve, so investors can fine tune a portfolio’s interest rate risk (duration) to match market views or client liabilities.

Modulate Credit Risk Ranging from investment-grade credit to crossover debt to senior loans to high yield, ETFs allow investors to control the amount of credit risk in a portfolio with ease and transparency.

Strategic and Tactical Uses

Launched in 2002, fixed income ETFs gained traction after the Global Financial Crisis. Price and holdings transparency and ease of trading drove that growth as many dealers reduced their balance sheets and transitioned from principal- to agency-based trading models in cash bonds.

Fixed Income ETFs allow you to:

Be Active with an Index Using the vast array of ETFs to optimize portfolios for precise yield, duration, spread, and sector, or even to naively reweight sectors of the Bloomberg Barclays U.S. Aggregate Index, investors can create custom portfolios across a wide array of bond subsectors.

Seek Active Management Offering both the potential benefit of active security selection and ETF tax efficiency, active ETF assets have grown to $394 billion — and the majority of ETF issuers reported plans to develop active ETFs in 2023.⁴

Replicate Beta The expansion of liquid ETF products supports more adaptable beta solutions to equitize cash or provide easy reinvestment of accumulated coupon payments.

Target Trends Investors can seek alpha by rotating efficiently in and out of asset classes based on macro, technical or fundamental trends. For example, investors can rotate into emerging market local debt in a declining rate and softer dollar environment. Or they can short ETFs to make relative value trades, such as loans over high yield, by executing on just two CUSIPs.

Additional Portfolio Uses

ETFs’ in-kind creation/redemption process also supports their use in a variety of other portfolio roles:

Transfer of Assets The breadth of securities owned by ETFs allow large investors holding single bonds to leverage the in-kind creation/redemption process to efficiently transfer select underlying bonds on their books into an ETF.

Transition Management If an asset manager receives an influx of cash, index-based fixed income ETFs can be used as temporary placeholders to obtain exposure while searching for a new manager. When a new strategy is decided on, investors working through an AP can redeem out of the ETF and take delivery of the individual bonds through the redemption process.

Inventory Consolidation Sell-side brokerage firms can use fixed income ETFs to manage the inventory held by their trading desks, consolidating positions across traders, and move bonds off their books by creating ETF shares that they can then sell in the market.

Derivative Alternatives

Fixed income ETFs provide alternatives to total return swap and credit default swap indices.

Also, investors can tap into ETF option notional value open interest on fixed income products for risk mitigation, income generation, or more advanced strategies.

Footnotes

Glossary

Alpha
A gauge of risk-adjusted outperformance that is measured relative to a benchmark because benchmarks are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund's alpha.

Bloomberg US Aggregate Bond Index
A benchmark that provides a measure of the performance of the U.S. dollar denominated investment grade bond market. The Agg includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US.

Bond
A debt investment in which an investor loans money to an entity — typically a corporate or governmental entity — that borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.

CUSIP
Stands for the Committee on Uniform Securities Identification Procedures. Formed in 1962, this committee developed a system that identifies securities, specifically U.S. and Canadian registered stocks, US government and municipal bonds, exchange-traded funds and mutual funds.

Duration
A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.

Liquidity
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.

Yield
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.

Disclosure

Investing involves risk, including the risk of loss of principal.

Diversification does not ensure a profit or guarantee against loss.

This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.

Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.

There can be no assurance that a liquid market will be maintained for ETF shares.

The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.

The trademarks and service marks referenced herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.

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