Bond ETFs: You Can Do Both?

In this episode we explore Bond ETFs. To some listeners, it may seem confusing as bonds and ETFs are usually separate products. However, we will be explaining what they are when they come together. Ron Delegge, ETFguide Founder joins Cassidy Clement, Senior Manager of SEO and Content to discuss.

Summary – Cents of Security Podcasts Ep. 71

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Today, I’m the host of your podcast. Our guest is Ron DeLegge, ETFguide’s founder. In this episode, we are going to explore bond ETFs. To some listeners, that may initially seem a little confusing. Bonds and ETFs are usually spoken about as separate products, but today we’re going to explain what they are and how they work when they come together. Welcome back to the program, Ron.

Ron Delegge:

Cassidy, great to be here. Thanks for having me.

Cassidy Clement:

Of course. So, you know, we were talking about ETFs and some of our brainstorms here for some topics. And of course, you know, you’re the ETF guy. So to just jump right in, I initially saw bond ETFs and I think, okay, well, I know they’re different products, but when they come together, it may seem pretty simple, but of course, like everything else, there’s caveats, there’s details, there’s all different pieces. So what exactly is a bond ETF and how did they come about in our market space?

Ron Delegge:

Well, it’s best to start with a quick explanation of how bonds work. Bonds are basically debt instruments. And so when you put your money into a bond, you’re effectively lending your money to a bond issuer. So what’s the payoff for the investor? Well, you’re going to collect income on the interest payments from that bond. And it’s the issuer who pays you the interest. And so bonds are used by both private and public companies, along with governments, municipalities. Basically they’re using it to fund their day to day operations. And some cases they may use bonds to expand an existing business venture or maybe to embark on a new project. But bond ETFs really make it easy, to invest in bonds. The first bond ETFs were actually launched way back in 2002, so it’s already been over 20 years. And, they were launched as a series. It wasn’t just one, it was actually four ETFs, three of them were U. S. Treasury Funds with varying maturities, and then there was one U. S. Corporate Bond Fund, and at the time when these ETFs were launched back in 2002, it was a major breakthrough, Cassidy, and it really opened up the way for investors to get access to fixed income or bonds, through an ETF structure.

Cassidy Clement:

Yeah, I mean, when we’re talking about bonds, usually people are thinking more of like the fixed income side, a little bit more of a gradual type of investment but when you start to talk about ETF, sometimes it’s completely opposite. I mean, of course, there’s value and growth types of investments, but usually people are looking at it a lot more, from, you know, the equity space.

But, When it comes to these actual pieces of bond ETFs, how do they work and what exactly are the pros and cons that come with them? Because the general thought process is, okay, it’s an ETF so I have some, variation of choice when it comes to, the cost of this and the performance that I’m looking to get may be a mix. But what are the liquidity factors and what is the difference with the maturity date? Since that’s something that sometimes people don’t always think about with ETFs.

Ron Delegge:

Yeah, there’s, there’s definitely a lot to think about. As you had mentioned there, I mean, obviously the benefits, you know, there’s a lot of pros, obviously diversification, you gain exposure to diversified portfolio bonds in a single transaction. And that’s a lot different than investing in an individual bond, which concentrates your risk to a single issuer. You can also spread that risk across different issuers, different sectors, different maturities. You even have what’s called a, you know, single year or target maturity date bond funds so that the bond ETFs actually expire in a certain year. So you can actually customize the maturity to certain years.

So if you want to have bonds that are in a portfolio that expire in three years, there are bond ETFs out there that will allow you to customize the, length of that maturity, to that specific target year.

So that’s a real big advantage. And I think the other thing too, is the cost effectiveness, you know? What does it cost for a trader or an investor to trade and invest in individual bonds? You know, there’s some costs there to do that. But also, not all these bonds are necessarily liquid like the stock market. There’s a lot of bond issues that don’t trade on a daily basis, individual bonds, and you may have some issues with liquidity. And so I think what bond ETFs have done is they’ve opened up this world of fixed income and they’ve made it easier for investors, not only to access that portion of the securities market, but also to give them a little bit more daily liquidity so that you don’t have to sit and wait for a individual bond to trade. Maybe it doesn’t trade. So, doing it in a conjunction with, you know, diversified portfolio bonds, it just makes it a lot easier. And of course, the bond ETFs trade on an exchange, just like, you know, individual securities, single stocks, as well as, you know, equity ETFs. Functionality wise, they trade the same manner so that’s something most investors can easily understand.

Cassidy Clement:

So with this, ETF style, most listeners will be familiar with the general structure of a bond. You’ve got your payment every month with the specific coupon, but how does it work with that ETF specifically since there’s many different things that make it up? Does the coupon vary from month to month based on the outcome of the bonds within it? How exactly does that work from an investment perspective?

Ron Delegge:

Yeah. So it depends on the type of bond ETF, but typically, bond investors will not need to replace that bond in the setting of a bond ETF. So typically as those bonds mature within the portfolio, they’ll be replaced, by new bonds that are issued. And so it’s this constant, you know, maturing and replacement process. That’s all done internally inside the bond ETF itself. It’s not something that investors really have to worry about. Whereas, you know, getting back to your point of the pros and cons, I think one of the potential cons of investing in individual bonds is you have to be very hands on with that process, right? Because your bonds are maturing. If you own them, you know, as single issues, and then you got to do something with them, right?

Do you leave that money in cash? Do you replace it with new bonds? What do you do? What do you do to maintain exposure to bonds in your portfolio? They’re supposed to represent X percentage of your overall portfolio, what are you doing to maintain that exposure? When you’re investing in individual bonds, there’s a little bit more hands on mechanics involved, whereas with the bond ETF, it’s kind of being done for you you know, automatically. Now, as I alluded to earlier with the target date bond ETFs, that’s sort of already done for you. Those types of bond ETFs, once they mature, all that cash is returned to the investor at the end of the maturity and basically it goes away and then you can start over and invest in, a new series of bonds with a different target date or something else. So, again, that’s kind of done for you. The other thing to think about in, in reference to your question about income payments, it really depends on the type of bond that we’re talking about.

Typically payments generally will happen either monthly or quarterly. But, those income payments, you know, get passed on to the investor. And so, you just have to read the fine detail, read the perspectives as we always like to say, and you’ll find out exactly how often, that bond ETF is paying its income.

Cassidy Clement:

For purchasing these products, since, you know, most people are thinking, okay, well, they do sound like a blend. Is anybody able to purchase something like this? Where can I purchase it? How exactly does somebody go about this? Is it like a normal item you’d find in an exchange at a broker? Are they purchased like common securities? Or are they something a little bit more involved?

Ron Delegge:

Yeah. Investors can buy and sell bond ETFs through a brokerage account. Just Like stocks just like, you know, normal ETFs and other securities that trade on exchange. So it really eliminates the need for a specialized bond broker. And it can really simplify the investment process. There’s not, a lot of, you know, red tape or bureaucracy involved.

Cassidy Clement: Is there any restriction on time frame for the time of day that you’re able to trade it or that it prices it at?

Ron Delegge:

As long as the market’s open. So as long as a market’s open, normal business trading hours. You know, typically you’ll be able to buy and sell a bond ETF without any problem. Of course, on holidays, you know, you’ll have the bond market. It won’t necessarily coincide a hundred percent with the equity market so there will be some times when, you know, the bond market’s closed and maybe, you know, major stock exchanges are open. But that’s pretty rare.

Cassidy Clement:

When we’re looking at this market and people start to say, okay, the time feels right for me. And I’m ready to enter the market in terms of bond ETFs. What are some things that they should keep in mind before investing? I know we already touched on the fact of different maturity dates, liquidity factors, the way that things are managed of how hands on versus hands off you want to be, but what are some of the main parts that people should keep in mind?

Ron Delegge:

Yeah. I think there’s a lot of decisions to be made here. First thing is context. So whenever thinking about adding anything to an investment portfolio, whether it’s bond ETFs, equity ETFs, cryptocurrency linked ETFs, anything, what is the context? How does it compliment? the overall investment portfolio. What does the investor’s investment policy statements say about this, right? What percentage of the portfolio should be earmarked for this investment? So if we’re talking about bonds and bond ETFs and investing in them, then that that’s the context. Thinking about how that fits in and complements the rest of the portfolio. The other thing too, that needs to be thought about is what is the, bond strategy going to be? Is it going to be a plain vanilla index? A broadly diversified approach? Low cost? Extremely low cost? You know, that’s typically what you get with a bond index ETF. Is that going to be the strategy and the foundation?

Or is it going to be maybe an active strategy where there’s a professional money manager involved, who manages the bond ETF. So, you know, that’s a different level of management. You might have both in the same bond portfolio. You might have some indexing and some active management. Then the other thing is, would you want to be strategic in your choices, right? Do you want to maybe emphasize certain aspects of the bond market, maybe certain sectors of the bond market? Maybe you want to take a position that is more, you know, strategic in nature, maybe more short term that is more active, versus a long term buy and hold type of situation. You might combine both. You might have some long term holdings that are committed to bonds and maybe some more tactical short term holdings where you might be using some inverse or some leveraged bond ETFs to accentuate or enhance the overall portfolio. Perhaps even be defensive. You know, maybe you’re trying to defend in a market that is sort of chaotic, maybe you’re trying to be defensive of the portfolio. And, so you might employ some strategies for hedging. So there’s a lot of things that, investors need to think about, but, you know, again, I think bond ETFs offer a lot of wonderful choices and flexibility and opportunities for investors to reach their investment goals.

Cassidy Clement:

One of the things that I had written down, in my notes and my research is obviously we talked a little bit about being cost conscious and, you know, your exposure to different sectors, how that happens throughout some type of a fund being managed, but correct me if I’m wrong, something like this also allows for investors to maybe get access to certain types of bonds that they may not have met the minimum investment threshold and that’s very big. I mean, when you think about something like a tech ETF, allows you to have access to Tesla or Amazon, which you maybe couldn’t afford as one full share, only fractional, you know, now you’re able to invest to get some of that exposure. When it comes to things like that, are there certain types of pros or unknown positives that people might not be aware of, that they get access to with these because it’s not just like, here’s a bond, any old bond, there is some of the we’ll say fun features that come into play with these investments.

Ron Delegge:

Yeah, a hundred percent. That’s actually a great point. That was one of the pros that I forgot to mention that there’s no minimum investment. And certainly, you know, for investors that are maybe dollar cost averaging or maybe new, maybe they have a smaller portfolio that’s a consideration you know? Unlike individual bonds, which often require a significant minimum investment. You don’t have that with bond ETFs. You may have that with a bond mutual fund also, but you don’t have it with bond ETFs.

And so, you know, investor, what that means is they can buy as few as one share if they wanted to in theory. I don’t know why you would do that, but I suppose you could, but you can buy as few as one share or obviously add to that, but it just provides you a level of you know, flexibility and not having to worry about investment minimums and being able to access a market as opposed to avoiding it altogether, right? If you didn’t have that flexibility at the bond ETF offers of buying as few as one share or getting rid of those investment minimums, what is the investor likely to do? Probably just avoid it altogether, which would result in probably a less diversified, perhaps higher risk portfolio, which I think we could all agree on. It probably is not a good thing.

Cassidy Clement:

Right. I mean, that’s kind of the exact idea of why I considered this topic for one of our episodes was a lot of investments seem daunting, complex, but also there’s a lot of barriers to entry. And in some ways, if you just look a little further, there are actual ways for you to gain exposure to the market. This is an example of one of those, which is maybe you don’t meet that threshold to help actually diversify the portfolio the way that you would like. But there are ways to go about it, it’s just a more windy road of research, maybe, because there’s other bonds involved than just the one, maybe, that you were thinking about, investing in.

And then, of course, you have, any type of expense ratios and looking at how the fund is managed. But other than that, I think we’ve covered all of our points today. Thanks so much for joining us, Ron.

Ron Delegge:

Yeah. Cassidy, thank you so much for having me and it’s always a great to see you and we’ll hopefully get a chance to do it again.

Cassidy Clement:

Yeah, thanks so much. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Feel free to leave us a rating or review wherever you find your podcast. Thanks for listening, everyone.

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