Bond ETF, Bonds Exchange Traded Funds

By: EconomyWatch   Date: 4 August 2009

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Bond ETF is a kind of exchange traded fund that invests only in bonds. Bond exchange traded funds have corporate or government bonds as their underlying assets. A bond ETF can be traded throughout the day though it does not have the liquidity like other ETFs.

 

How Does a Bond ETF work?
 

Firstly, it is important to understand the concept of bonds before delving into how bond ETF works. Bonds are a debt investment in which traders or investors loan out their money to an institution (either government or corporate). These institutes borrow this money for a certain amount of time and at a fixed amount of interest. The interest rate is determined by the credit quantity and the duration of the bond.

 

In bond ETF trading, the current and the past prices are made available to the investors throughout the day for transparency. Due to lesser liquidity, the main challenge faced by the managers of the bond ETF is to track the changes of the underlying index cost in an effective way.

 

This problem is overcome by following a sample of bond ETF that is the closest representative of the managed bond ETF. For example, Lehman Aggregate Bond Index contains more than 6000 bonds whereas the Barclays iShare Lehman Aggregate Bond Fund has only 100 bonds. In this case, iShare bond follows the Lehman index.

 

Bond ETF pays out interest in monthly dividends and capital gains, annually.

 

Advantages of Bond ETF
 

Besides all the advantages of regular ETFs, bond ETFs offer other advantages like:

·        Bond ETF that invests in government bonds do exceedingly well during recession as the investors pull out their money from the market and invest in government bonds for security.

·        Bond ETF is an instant way of investing in a fixed income portfolio because of the fixed interest that it yields.

 

Disadvantages of Bond ETF
 

Due to brokerage and less liquidity, here are a few disadvantages of bond ETF:

  • Bond ETF costs an ongoing management fee which can eat into the profits.

  • Bond ETF does not offer the flexibility of creating something unique for higher profits.

  • Bond ETF has a higher trading commission. So, short term traders do not generate as much profit as they will otherwise.

 

Even with these flip sides, bond ETF is an exciting addition for the investors as it offers greater transparency and lesser risk.

 


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