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If you’re thinking about investing in bond exchange-traded funds (ETFs) instead of mutual funds, you’re not alone.
Bond ETFs have seen nearly $344 billion in inflows through Oct. 31 of this year, compared to $138 billion in fixed income mutual funds, according to Morningstar Direct. This is part of a larger trend of investors favoring ETFs, with about $74 billion flowing out of mutual funds and $166 billion flowing into ETFs in October alone.
And while ETFs have some advantages over mutual funds, and bonds are considered a safer investment than stocks, experts say it’s important to know what you’re buying.
“You have to remember the role of bonds in your portfolio,” said Dan Sotiroff, senior analyst for passive strategies research at Morningstar. “Usually it acts as a ballast. How big to make is something you have to decide on your own or with an advisor.”
“Legitimate Edge”
Both mutual funds and ETFs allow you to invest in funds that combine the underlying investments. The benefits of ETFs range from low cost to tax efficiency to all-day trading on the open market. (Mutual funds are priced once a day and only after the market closes at 4:00 PM ET.)
One reason assets are flowing into bond ETFs is simply that in recent years, especially actively managed ETFs have become more popular, meaning professionals are choosing which bonds to invest in, whereas until now bond mutual funds were the only area. In contrast, passively managed ETFs track an index and their performance mimics that benchmark, for better or for worse.
“There are legitimate advantages to active management,” Sotilov said. Managers there “can bring something different to the equation and aim to outperform the benchmark.”
According to Morningstar, the number of actively managed bond ETFs (511) exceeded the number of passively managed bond ETFs (393).
Active funds have higher expense ratios (the annual fees paid by investors expressed as a percentage of the fund’s total assets). Investors pay an average of 0.35% for actively managed bond ETFs, compared to 0.10% for passively managed bond funds.
Know what kind of bonds you’re buying
Also note that because bonds pay interest, ETFs distribute monthly payments to investors, and investors are subject to taxes on that income if the ETF is held in a taxable brokerage account. If it’s in an individual retirement account or 401(k) account, the growth grows tax-deferred and is taxed at ordinary income tax rates if the funds are withdrawn after age 59 1/2. Withdrawals are tax-free when held in a Roth IRA account.
And whether you’re considering a passive or active bond ETF, experts say it’s important to consider the type of bond you’re investing in. For example, U.S. Treasuries and corporate bonds with solid credit ratings are considered investment grade, meaning they have a low risk of default.
“The correlation with stocks is very low, so it’s important to keep that in mind” when diversifying, Sotilov said.
Investment-grade bonds tend to have lower returns than riskier bonds, while high-yield corporate bonds with lower investment ratings have higher yields but are more likely to default.
If you rely on bonds for your retirement income, trying to squeeze too much income out of your bond portfolio can be counterproductive.
Tim Videnka, chief investment officer and principal at Forza Wealth Management in Sarasota, Fla., and a certified financial planner, said bond ETFs “need to be liquid and high quality because they’re essentially funding the client’s living expenses.”
Bonds also lose money
But like any investment, you can lose money with bonds, Videnka said.
In 2022, when the Federal Reserve began raising benchmark interest rates to combat high inflation, bond prices fell (prices move inversely to yields), and the year ended as the worst bond year in history, with major bond indexes posting huge losses.
2022 “showed that there can be losses in the bond market,” Videnka said. “Sometimes people forget what happens when there is real fear.”
One reason why bond prices fall when interest rates rise is because newly issued bonds command higher interest rates, reducing the value of existing bonds with lower interest rates and pushing down their prices.
The Fed lowered its benchmark interest rate (federal funds rate) for the second time this year in October, but it remains much higher than it was several years ago, when the Fed began raising rates in 2022. The federal funds rate, the interest rate that commercial banks charge each other on overnight borrowings to meet reserve requirements, ripples through the economy and affects the interest rates charged on mortgages, auto loans, and credit card debt, as well as on bonds and savings accounts.
“If you go back 15 years, after the[2008-2009]financial crisis, we were in a 0% interest rate environment, and then the coronavirus hit and we were back in a 0% interest rate environment,” Sotilov said.
“Now we actually have (positive) interest rates and some returns that make bond ETFs attractive,” he said.
