If you’re considering investing in bond exchange-traded funds (ETFs) instead of mutual funds, you’re not alone.
According to Morningstar Direct, bond ETFs attracted nearly $344 billion as of October 31 of this year, compared to $138 billion for bond mutual funds. This trend is part of a broader shift in investor preference toward ETFs: In October alone, roughly $74 billion flowed out of mutual funds, while ETFs attracted $166 billion.
While ETFs offer some advantages over mutual funds, and bonds are generally considered safer investments than stocks, experts emphasize the importance of understanding what you’re buying.
“You have to consider the role of bonds in a portfolio,” says Dan Sotiroff, senior passive strategies analyst at Morningstar. “They generally act as a drag, and it’s up to you or your advisor to determine the importance of this role.”
An undeniable advantage
Both mutual funds and ETFs allow you to invest in a fund composed of a diversified portfolio. ETFs offer numerous advantages: lower fees, favorable tax treatment, and continuous trading on the open market. (Mutual fund prices are quoted only once a day, after the markets close at 4:00 p.m. EST.)
The influx of assets into bond ETFs is largely due to their proliferation in recent years, particularly actively managed ETFs (meaning professionals choose which bonds to invest in), a prerogative previously reserved for bond mutual funds. In contrast, passively managed ETFs replicate an index, and their performance closely reflects that index, for better or for worse.
“Active management has a clear advantage,” Sotiroff stated. Managers “can bring a different perspective and aim to outperform their benchmark.”
According to Morningstar, the number of actively managed bond ETFs (511) has surpassed that of passively managed bond ETFs (393).
Active funds have higher management fees, which are the annual fees investors pay 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.
Do your research on the bonds you buy.
Keep in mind that because bonds pay interest, these ETFs distribute monthly payments to investors. This income is taxable if the ETFs are held in a taxable securities account. If held in an Individual Retirement Account (IRA) or a 401(k), the gains are tax-free when withdrawn after age 59½, depending on the tax brackets. However, withdrawals are tax-free if held in a Roth IRA.
According to experts, whether you choose passive or active bond ETFs, it’s crucial to carefully select the types of bonds you invest in. For example, U.S. Treasury bonds and corporate bonds with strong credit ratings are considered high-quality investments, meaning they carry a low risk of default.
“The correlation with equities is very low, and it’s important to keep this in mind” when looking to diversify your portfolio, Sotiroff said.
High-quality bonds tend to generate less income than higher-risk bonds, while high-yield corporate bonds, even with a lower rating, can offer higher returns but carry a higher risk of default.
If you rely on bonds for your retirement income, trying to generate excessive returns could backfire.
Bond ETFs “essentially fund our clients’ day-to-day expenses, so it’s critical that they be liquid and high-quality,” said Tim Videnka, a certified financial planner, chief investment officer, and senior partner at Forza Wealth Management in Sarasota, Florida.
Bonds can also lose value.
Like any investment, bonds can also lose value, Videnka noted.
In 2022, when the Federal Reserve began raising its key interest rate to combat high inflation, bond prices plummeted (prices move inversely to yield), and the year ended with a record low for bonds, with major bond indexes posting significant losses.