The stock markets are the focus of most investors. They know little about bonds. Fixed income securities should also play an important role in portfolios. However, the differences between individual bond ETFs are large. There is an almost unmanageable abundance of products that carry the bond ETF label. But security is not always there where it says bond ETF. The risk of individual exchange-traded index funds in this segment differs enormously in some cases.
WHAT MAKES BOND ETFS DIFFERENT
The financial industry divides bonds according to various criteria, which ETFs are also based on.
Issuer – There are funds that invest exclusively in government or corporate bonds . Some focus on bank bonds, which in turn are mainly secured by real estate loans. The latter are classified on the capital market as almost as safe as bonds from countries with high creditworthiness. This can be seen from the only slightly higher interest rates compared to such government bonds.
Creditworthiness – Many ETFs only buy bonds from issuers with good credit ratings. The latter can be read from the so-called rating . It is awarded by specialized agencies.
Issuers with credit ratings ranging from “average” to “excellent” are allowed to adorn themselves with the “investment grade” seal of approval. Bonds without this rating are considered junk. They are also known as junk bonds, junk bonds, high-yield bonds or high -yield bonds. Because they are more likely to default, they generate higher returns than investment grade bonds.
INTERPRETING THE KEY FIGURES OF BOND ETFS CORRECTLY
Bond ETF providers usually publish some metrics that help assess opportunities and risks. The most important are:
Effective Interest (Yield to Maturity) – This indicates the average annual return on the bonds contained in the ETF if they were held to maturity. This metric is sometimes called the Yield on Payback. For investors, however, it is only a rough guide, because ETFs usually do not keep the bonds until they expire. The effective interest rate reflects the current interest rate level in the respective market in which the fund invests.
Current yield – It is calculated from the relationship between the coupon and the price of a bond. Investors call the interest coupon the fixed interest payment that they usually receive annually for a bond. With a bond ETF, the current return is calculated from the weighted averages of the interest coupons and the prices. In the case of exchange-traded index funds that distribute their interest income, it is an indication of the expected payout amount in the respective payment period. In contrast to the effective interest rate, the current return only ever relates to one year.
Creditworthiness affects the prices of bonds
Debtor credit upgrades and downgrades can also result in profits and losses for bond ETFs. In particular, a downgrade from an investment grade rating to junk can result in drastic losses in value. Someone who has ever taken out a loan knows that the interest rate paid by the bank depends on the creditworthiness of the borrower. A senior civil servant with a permanent job and high income usually only has to pay low interest. A self-employed person with fluctuating income, on the other hand, a high one, if he even gets a loan.
BOND ETF TRADING RISKS
Unlike stocks, bonds are not a particularly liquid asset class . While buyers and sellers can almost always be found on the stock exchanges for the shares of large companies, this is not necessarily the case with bonds. Many are not traded on stock exchanges, but only on isolated marketplaces between banks, funds and other professional investors. In a stressful phase, for example during a stock market crash , trading with poorly liquid bonds can stall or even come to a standstill because the pricing mechanism no longer works properly. Investors are no longer sure what value certain bonds have and are therefore unwilling to buy or sell.
This also has unpleasant consequences for bond ETFs that are continuously traded on exchanges. With growing volatility, the disparity between purchase and sale rates, the so-called gap, skyrockets. At the same time, bond ETFs’ stock market rates will differ considerably from their indices. There is then an especially high chance of having a bad bargain while exchanging bond ETFs with private buyers, i.e. either selling too poorly or buying too expensively. In the Buy and Sell ETF report, you can learn all about this.
In the case of bonds, especially risky corporate bonds and emerging market bonds, there is therefore a not inconsiderable liquidity risk, which became apparent during the Corona crisis, for example. On the other hand, selling securities in the middle of a crash has never been a good idea. For those who pursue a buy-and-hold strategy and consistently sit out crises, trade risks only play a subordinate role.
WHY BOND ETFS ARE BETTER THAN ACTIVELY MANAGED BOND FUNDS
As with equity funds , investors also have a choice with bond funds: They can choose between bond ETFs and actively managed bond funds, in which a manager selects the bonds.
With an actively managed fund, investors have the opportunity to achieve a higher return than the market average. But there is also the risk of ending up worse off. And this risk is considerable, as various studies show. Very few bond fund managers manage to beat their respective market averages. In addition, managers tend to take higher risks in order to whip up the returns of their funds. For example, some bond funds, which are actually focused on safe euro government bonds, sometimes also buy riskier papers such as corporate and high-yield bonds or stocks and other securities with high profit and loss opportunities. It is also common to hold more bonds with poorer ratings and higher yields than the benchmark index. With a bond ETF, on the other hand, it is always transparent which paper the fund currently contains.
BOND ETF IN THE PORTFOLIO
A not without risk of misunderstanding among private and professional investors is the tendency to lump all bonds together. Fixed income securities are booked on the safe side in most portfolios. But that is a mistake. High-yield bonds from highly indebted companies behave more like stocks and not like euro government bonds from countries with very good credit ratings. The same applies to emerging market bonds . Both asset classes are ideal for diversifying an ETF portfolio . But they are part of the risky part of the portfolio, along with stocks, commodities, and gold. On the safe side of an ETF portfolio, which is intended to dampen price losses in the event of a stock market crash, only investments that are really largely safe are to be looked for. These include bond ETFs on euro government bonds. Due to their comparatively stable performance, these ETFs are an important building block for long-term portfolios.