The Bond ETF: A Profitable Alternative to Index Bond Funds?

In some cases a bond ETF may be a profitable alternative to index bond funds, but the forces that affect each are somewhat different. When you switch from a stock index fund to an indexed ETF, there are few differences. The mechanics of stock mutual funds and ETFs are very similar. With bonds, these differences are more significant and can make comparing them more difficult. You should spend the time to make this comparison, however, because if you do not, the results you achieve may be other than expected.

The Mechanics of a Bond Index Fund

When you invest in a bond index fund, the manager attempts to duplicate the performance of the index by purchasing a basket of bonds with the proper characteristics. Performance is driven by both fluctuations in the prices of the bonds and the interest payments that are received. The fact that a significant part of the return is generated by income is important. The manager manages these cash flows, using some to pay you back at redemption and reinvesting another portion. Regardless of what index the manager is tracking, income tends to be an element of the process.

The Mechanics of a Bond ETF

Unlike many bond index funds, a fair number of bond ETFs invest in zero-coupon bonds. This means that performance is more directly tied to fluctuations in the yield curve and are less dependent on income. TLT, for example, tracks ten-year treasuries, but does so following the performance of zero-coupon bonds. A zero-coupon bond does not make interest payments. Its price is discounted significantly enough that as it moves to maturity, and par value, the return is completely price driven. While there are some bond ETFs that track other bond indexes, because they can be bought and sold all day, they often track these indexes synthetically.

The other major mechanical difference is that because ETFs trade throughout the day on an exchange, their prices are affected by market forces like stocks. This does not always have a significant impact, but understanding these forces will help you to get a clearer picture.

Differentiating Factors

As was mentioned above, there are some bond ETFs that track various bond indexes. In the case of TLT, for example, because the managers are using zero-coupon bonds, certain features will be different. Zero-coupon bonds tend to be more volatile and face different risks. You are completely at the mercy of the price action. With standard bonds, you always have the option of holding the bond to maturity. This will ensure that you receive the expected return, unless there is a default. When handling zero-coupon bonds, you can hold them to maturity, but this is rarely practical within a fund.

Lastly, where a bond index fund will set its net asset value (NAV) to reflect each day’s interest, thus smoothing performance, an ETF’s price is not smoothed. If you study the differences between the fund and the ETF you are considering, matching your objectives to the right investment, an ETF can be a more profitable alternative. Making these choices requires careful research and should be made on a case by case basis.

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