Bonds are much safer than a lot of other investments and provide a steady income. Now with bond exchange traded funds, it is possible take advantage of the investment opportunities they offer in new ways.
Advantages of exchange traded bond funds
While people invest in bonds for the stability and steady income they offer, many want more diversity in their bond investments. Furthermore, people often want more liquidity. ETF bond funds allow people to buy and sell bonds like they are stocks and thus make bond investing more liquid. In addition, since they are invested in a number of funds, they also give diversity. Finally, investors do not have to concern themselves with the bonds expiring (the ETFs will keep them current).
Investors can get many of the same benefits from mutual funds that specialize in bonds as they can from exchange traded bond funds. However, ETFs will offer lower fees and more liquidity than mutual funds. On the other hand, it is harder to set up automatic reinvestments with ETFs, and their management is less active.
Taxes and income
ETF bond funds will pay monthly dividends. They also will pay any capital gains annually. Therefore, unlike ETFs invested in stocks, they do not offer control over when capital gains are taken. However, since capital gains are not significant in bonds, this is not an important factor.
Changes in bond prices
EFT bond funds will fluctuate in value just like regular bonds do. With rising interest rates, bond prices will fall as will the value of the ETF. When interest rates drop, the opposite is true.
In addition, just like regular bonds, those considered most risky will pay more interest than bonds that have less risk.
Types of bond ETFs
One advantage of bond ETFs is that they can be found for virtually every type of bond and can be purchased for more general or specialized categories. The most popular are as follows:
US treasury bonds: These have long been considered some of the safest bonds. Issued for 10 years, they pay dividends twice a year and are taxed at the federal level.
Corporate bonds: Companies use these bonds to raise money for expansion or other purposes. Usually issued for a year or more, they generally pay higher yields than government bonds since the risk of default, depending on the company, is greater.
Municipal bonds: Issued by city, state and local governments to raise money, the major advantage of these bonds is that they are usually exempt from both federal and state taxes.
International bonds: These bonds, sometimes called sovereign bonds, are basically the same as bonds issued in the US. However, they are usually denominated in the currency of the nation they are issued in. This makes them subject to fluctuations in currency values that can bring either a gain or a loss to the purchaser depending on which way the currency moves. Although they are often considered a higher risk, they can bring better returns.
Junk bonds: Now usually referred to as high-yield bonds to avoid negative connotations from the name, these are basically bonds that carry a higher risk of default but pay higher yields. They typically pay 4-6% above bonds issued by the US Treasury and offer attractive rates of return for those less averse to risk.
For a complete listing of the different types of bonds, see ETFs.