A Simple Guide to Bond ETFs

12/19/2011 11:52 am EST

Focus: BONDS

Rob Carrick

Columnist, The Globe and Mail

These alternatives to individual bonds or bond mutual funds offer several advantages, writes Rob Carrick, reporter and columnist for The Globe and Mail.

The seemingly simple bond ETF could be the most misunderstood investment of the past few years.

Exchange traded funds holding bonds account for a little over 25% of the $42 billion invested in ETFs in Canada, and they make up four of the ten largest ETFs. Investors have clearly taken to bond ETFs as an efficient, low-cost alternative to both bond funds and buying bonds individually.

But if the queries I get from readers are any indication, some of the people buying bond ETFs don’t fully understand how they work. To clear things up, this edition of the Portfolio Strategy has been designed as a bond ETF owner’s manual.

Product Description
A bond ETF is a vehicle for investing in any one of a wide variety of indexes tracking bonds of all types, including those issued by governments and both blue-chip and less financially stable corporations.

Ideally, investors get the return of the index tracked by a bond ETF, minus the expense ratio and any fees charged by an investment advisor (not applicable to do-it-yourself investors).

Bond ETFs trade like a stock, so brokerage trading commissions must also be considered. Note that some brokers now offer commission-free ETF trading.

How to Use a Bond ETF
Some bond ETFs are designed to provide diversified all-in-one coverage to the entire bond market, including government and corporate bonds.

Other products are designed to allow investors to shape their own bond portfolio. For example, they could combine low-yielding but safe short-term government and corporate bonds with real-return bonds for inflation protection and high-yield bonds for extra returns (and risk).

How Bond ETFs Differ from Actual Bonds
Like bonds, bond ETFs will rise in price when interest rates fall and decline when rates rise. But whereas a bond will eventually mature and pay you your investment back, bond ETFs continue to track their respective bond indexes without ever maturing.

How Interest Is Paid
Even though individual bonds typically pay interest twice a year, many bond ETFs pay interest on a monthly basis. Some ETFs pay more or less the same amount every month, while others vary the amount of cash somewhat.

How Income from Bond ETFs Is Taxed
Mainly interest income, but you may see some capital gains and also a small return of capital as well if you own a growing ETF. That’s due to accounting rules for ETFs that take in lots of new money.

[Because this article was originally written for a Canadian audience, rules may vary. If you’re uncertain about your holdings and their potential liability, contact a financial or tax advisor—Editor.]

What You’ll Pay to Own Bond ETFs
At the low end, investors can pay as little as 0.17% to own a bond ETF holding short-term bonds. It’s hard to see why, but MERs are higher for ETFs holding longer-term bonds, corporate bonds, and high-yield bonds. MERs at the top end come in around 0.65%, which compares with an average of 1.2% for the ten largest bond mutual funds.

Why Own Bond ETFs Instead of Individual Bonds
Small investors are at a disadvantage in the bond market from the get-go: Institutional investors—such as the ones managing bond ETFs—pay a fair bit less to buy bonds than individual investors. The lower the price paid for a bond, the higher the yield.

Your Return from Bond ETFs
Do not make the mistake of getting a stock quote for a bond ETF and judging your actual return by using the yield displayed. This yield number is based on the previous 12 months’ worth of interest payments and the current share price for the bond ETF.

Use this so-called distribution yield as a guide to how much income you can expect from the ETF, much like the coupon on a bond. The coupon represents the interest payments a bond makes.

The correct measure of the return on a bond ETF is yield to maturity, which can be found on the product profiles that all companies selling exchange traded funds offer on their Web sites. Yield to maturity is an estimated number because of various assumptions that go into the calculation. Still, as one ETF industry person puts it, "it’s the best you can do" to determine your yield.

One further step: Reduce the displayed yield to maturity by the management fee to get a net return.

Some investors nevertheless continue to focus on the distribution yield over yield to maturity, and it’s easy to see why. In virtually all cases today, the distribution yield is much higher.

Take the largest bond fund in Canada, the iShares DEX Universe Bond Index Fund (Toronto: XBB). The distribution yield is 3.6% and the yield to maturity is 2.3%.

Why the discrepancy? Because a lot of the bonds in XBB were issued at a time when interest rates were higher than they are now. These bonds have risen above their issue price as a result, but they’ll gradually move back to that level as they approach their maturity date.

This price decline is factored into yield to maturity, which represents a total return that includes both the interest you’ll get and expected changes in the bond ETF share price.

Note that yield to maturity isn’t permanently lower than distribution yield. If interest rates move sharply higher, we could see a reversal of this pattern.

Miscellaneous Terms You Should Know

  • Weighted average coupon: An averaging of the interest payments made by bonds in the portfolio according to their weighting. Doesn’t factor in price movements for the bonds.
  • Weighted average duration: A measure of sensitivity to interest-rate changes. However many years of duration a portfolio of bonds has on average, that’s how many percentage points it will fall in price if rates climb by a single percentage point (the opposite applies, too). XBB has a duration of 6.7 years, which means an increase of 1 point would cause it to fall by 6.7 points. Short- and long-term bond ETFs in the iShares family have durations of 2.6 and 13.7 years.
  • Weighted average term: The average time period over which bonds in the ETF will mature.
  • Ratings: Tells you how bond-rating agencies have sized up the bonds held in the portfolio. BBB and higher are considered high quality. Less than that will give you higher returns, but more risk.

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