Getting acquainted with fixed income ETFs

Many investors invest in exchange-traded funds (ETFs) as they offer diversification, low management fees, transparency of pricing & holdings, tax efficiency and are tradable on stock exchange. Although the first ETFs were developed for equities, ETF providers in the US have branched out into fixed income ETFs, such as those that contain different asset classes. The bond market is not as liquid or transparent as the equity market. Also, unlike stocks, fixed income securities do not trade on an exchange. Fixed income ETFs can be as liquid and transparent as stock ETFs and trade on a stock exchange.

In a stock ETF, the fund is generally composed of all the stocks in the index. This is not the case in most fixed income ETFs. The fund holds a fraction of the bonds that make up the underlying index. A fixed income ETF is an exchange-traded fund that generally pays dividends and interest payments to investors in the ETF. These funds are a good choice for investors seeking a stream of income from a diversified set of stocks and fixed-income securities.

Fixed income ETFs are innovative tools for today’s markets, and more and more investors, financial advisors and institutional investors are finding out why. Fixed income ETFs, whose shares are traded on major stock exchanges, are a special type of mutual fund designed to track the performance of a specific bond market index.

A bond market index is a statistical composite, created and maintained by a financial institution that tracks the performance of the overall bond market or of a specific sector (government or corporate), maturity range or credit quality within the larger market. Different ETFs offer investors the opportunity to achieve broad bond market exposure. Unlike most bonds, fixed income ETFs generally trade on organised exchanges like the New York Stock Exchange or the American Stock Exchange.

Fixed income ETFs are normally exchange-traded funds that buy fixed-income securities. ETFs typically allow individual investors to speculate on securities without directly owning them. Unlike mutual funds, whose shares are priced once daily, ETFs are listed on exchanges and are bought and sold like stocks. Using ETFs to bring cash in stock markets is extremely common and this simple application of ETFs has barely started in fixed income markets. The use of fixed income ETFs is more common in the US bond market than in other countries but it still lags behind the use of mutual funds for fixed income investing.

Common brand names for fixed income ETFs include iShares, Standard& Poor’s Depository Receipts (also known as ‘Spiders’), Diamonds and Vipers.

An actual ETF based on fixed income product is one where the units can be traded on stock exchanges. These funds are popular in the US and are expected to be launched in India in the next three years, according to Goldman Sachs Asset Management (India).

The major reason for fixed income ETFs not becoming active in India is due to the illiquid nature of the underlying market for corporate and government bonds. The ETF on fixed income will track a bond index be it AAA or AA rated bond indices by indices manufacturers like rating agency CRISIL, Goldman Sachs AMC added.

The US fixed income ETFs are expected to boost their assets more than six- fold to $2 trillion in the next 10 years as they transform the way bonds are traded, according to BlackRock Inc. Fixed income ETFs have revolutionised the fixed income landscape and help bring liquidity, transparency and ETF diversification to investors. These funds provide exposure to hundreds of bonds in a single trade. These funds track the well-known indexes and holdings are disclosed daily, so investors know exactly what they own (and what risks they're taking). These can be bought or sold just like stocks throughout the trading day. In fast-moving markets, the difference between instant and delayed execution matters.

By buying fixed income ETFs, investors can obtain exposure to a certain segment of the fixed income market in one trade, reducing the need to research, price, purchase, and manage a large number of individual bonds. Fixed income ETFs are designed to track institutional quality indices much like bond mutual funds do, but fixed income ETFs can be bought and sold on a public exchange, like a stock. Fixed income ETFs tend to offer low management fees and increased liquidity.

Benefits of fixed income ETFs

  • Diversified exposure to various sectors of the fixed income markets
  • Low management fees
  • Transparency of pricing & holdings
  • Intraday tradability helps provide flexibility & liquidity
  • Tax efficiencyRisks associated with fixed income ETFs
  • As with any asset class, investing in fixed income entails certain risks. Prices of fixed income ETF shares are affected by the same factors that influence bond prices. The following is a quick summary of those risks:

Interest rate risk:

Rising interest rates mean declining bond prices and vice versa. As interest rates rise and fall the present value of the bond and its future cash flows will change, which, in turn, affects its market price.

Default risk:

The downside of holding individual bonds, especially corporate bonds, is the risk of default—the company that issued the bond might not be able to pay it back. Typically, bonds with lower credit ratings will offer higher interest rates to compensate investors for the additional risk.

One way to lessen this risk is diversification spreading your assets among a lot of different bond issuers. ETFs excel at diversification, because when you own an ETF you own a fractional share of a pool containing lots of different securities.

Prepayment risk:

The risk that a bond with a callable feature is called by the issuer. From an investor’s standpoint, this is disadvantageous because of the uncertainty of cash flows and the potential exposure to reinvestment risk.

Reinvestment risk:

The risk that cash received from a callable or maturing bond is reinvested at a lower interest rate.

Market risk:

The risk that an overall market decline may adversely affect the value of individual issues even though those investments still have strong fundamentals.

Liquidity risk:

The risk that an investor may be forced to sell a security at a loss due to difficulty of finding a buyer (a greater risk for thinly traded individual bonds).

Inflation risk:

Inflation is the rate at which purchasing power is decreased over time; that is how much you can buy today with Rs. 100 vs. how much you will be able to buy 10 years from now. The longer the investor has to wait to get his or her initial principal back, the greater the chance that higher than expected inflation will reduce the value of the principal and interest payments.

Fixed income ETFs vs bonds

Fixed income ETFs usually distribute monthly dividends which can include both interest income on the underlying bonds and capital gains (if any). This means fixed income ETFs basically provide regular income, such as interest payments from bonds and dividend payments from stocks.

Most bonds have a coupon, which means that they will distribute interest payments to their holders on a regular basis (often twice a year).

Unlike bonds, ETFs have no maturity date. Although bonds in the fund mature eventually, the proceeds are reinvested in new bonds rather than returned to investors. The only way for ETF investors to get their principal back is to sell the shares. The price received may be more or less than what was paid, depending on the direction of interest rates and other bond market conditions in the interim.

ETFs trade on stock exchanges, whereas bonds are generally bought and sold through dealer firms. Trading on a stock exchange means that investors can execute trades just as they would with any listed stock. Also, price quotes and trading history for ETFs are available in the same manner as for listed stocks.

Furthermore, individual investors can execute trading strategies in ETFs that may be cumbersome using bonds themselves. For example, ETFs can generally be sold short just as any listed stock, and for most fixed-income ETFs, there are actively traded options chains available to individual investors. Short sales and options on individual bonds generally are not available to individual investors.

Fixed income ETFs vs mutual funds

Fixed income ETF shares are bought and sold on a stock exchange, while open-end mutual fund shares are bought and sold directly through the fund sponsor. ETF shares are priced continuously throughout the day, and traditional open-end mutual fund shares are priced once daily. ETF shares can be bought or sold at any time during the day. Open-end fund shares can only be bought or sold at the end of the trading day. ETF investors pay a brokerage commission on the trade, while traditional open end mutual fund investors may have to pay a sales charge or other fees to enter or exit the fund. Many open-end mutual funds are actively managed, meaning the portfolio manager makes investment decisions in an effort to enhance performance relative to the market as a whole. As a result, open-end funds tend to impose relatively higher management fees than passively managed (indexed) funds. ETFs are always indexed and tend to have management fees and expense ratios significantly lower than actively managed funds and in some cases lower than other index funds.