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Why Your Portfolio Needs Bond ETFs

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Exchange traded funds or ETFs are to the investment market what the IPhone may be to the cell phone market. It’s one of the fastest growing, game changing products to hit the investment markets since the 401(k). There is an ETF for just about everything and what makes them so popular is their relative low cost. Never before could you invest in mutual fund like products at a fraction of the mutual fund cost.

For most retail investors, they know of some of the more popular ETFs like the SPDR S&P 500 or the SPDR Gold Shares with the really cool vault full of Gold in an undisclosed location in the UK. What they don’t know about is the less flashy but equally important bond ETFs. Fixed income may not be exciting to watch but a large portion of the gains in a long term portfolio come from fixed income products or dividend paying stocks. Here’s how to add Bond ETFs to your portfolio.

What’s Wrong with Bonds

Why buy ETFs when you could just as easily buy bonds? Because buying bonds isn’t easy at all. First, bonds are often out of the price range of individual investors. Most bond brokers require a minimum purchase of $5,000 which may be out of the price range for most individual investors. Even if that’s within your capital level, it’s difficult to keep a diversified portfolio with that much money tied up in a single bond. Second, bonds are more difficult to buy and sell, and understanding the mechanics of bonds may be outside the scope of part time investors.

What’s a Bond ETF?

A bond ETF is a product that tracks the performance of a certain basket of bonds, a bond index, or other benchmark relating to bonds. The best reason to add these products to your portfolio is the advantage of giving you exposure to the bond world at any weighting you would like. If you only have a $5,000 portfolio but you want $1,000 of it in bonds, you can do that with bond ETFs.

You also get a level of diversification that you wouldn’t get purchasing individual bonds. Some Bond ETFs invest in hundreds of bonds so if one bond defaults it has little impact on the fund as a whole. No individual could achieve this kind of diversification and risk mitigation purchasing individual bonds.

Bond ETFs are also less volatile than individual stocks or stock based ETFs. Investors purchase bond ETFs to gain the dividend stream that comes as frequently as monthly on some ETFs but don’t expect a lot of capital appreciation.

How Do I Invest?

Although you don’t need an academic understanding of the mechanics of bonds, before investing in a bond ETF you should know how bonds work, how they’re priced, and the market conditions that affect their performance. Also understand bond ratings and how an investment grade bond differs from a junk bond. Click here to learn more.

Once you learn the basics, consider adding an investment grade bond ETF, an emerging markets or other foreign markets ETF, and a below investment grade or junk bond ETF. If you’re nervous about investing in below investment grade bonds remember that because these funds invest in so many bonds, the risk is largely mitigated.

With any ETF, you have to look at the fees. Some of the passively managed ETFs have very little fees where the more actively managed funds may have fees that are as much or more than some mutual funds. In general, keep the total fees below 1% although some actively managed funds may be worth a little more depending on performance.

Remember

All portfolios with the goal of long term growth should have some fixed income as part of their holdings. Bond ETFs are rapidly becoming the way to cash in on the yield that comes with fixed income investing without the hassle or diversification problems that accompany buying individual bonds.

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6 Responses to “Why Your Portfolio Needs Bond ETFs”

  1. eric says:

    I think taxes/taxable accounts should play an important role in determining whether you choose bond MFs or bond ETFs also.

  2. Kurt says:

    Bonds surely can play an important role in an investment portfolio, but given that interest rates are at historic lows and bonds have performed spectacularly the past decade or so, isn’t now about the worst time in the past 50 years to buy bonds or bond funds?

    My brokerage firm (I won’t name it but they run tv commercials featuring talking babies) makes it very easy to buy all sorts of individual bonds through its website. I can buy in $1,000 increments, which I believe is standard (not $5,000). I pay a very small, fixed commission, and it’s one time vs. an annual fund fee. It’s no more difficult for me to buy & sell bonds through this site than it is to buy & sell stocks, i.e., both are easy.

    On the downside, diversification cannot be done nearly so well as through a bond fund, and the burden is on me to do creditworthiness research. To help minimize risk, I buy bonds that will mature in one year or less, and research the issuer before purchase. I’ve never suffered a principal loss (knock on wood), even through the 2008-09 meltdown.

  3. timparker says:

    Thanks for the comments, Kurt

    Generally, you don’t buy bonds for capital appreciation. If that’s what you want, stocks are a better plan. We normally put people in bonds for yield and with that said, bond funds, some with a high degree of safety relative to stocks can pay 6% or more. For that reason, it’s still the perfect time to buy bond etfs. I’m not a bond fan unless they’re short dated to avoid interest rate risk. Even then, you can invest in a diversified below investment grade bond etf with a safety profile of an individual investment grade corporate.

    Bonds are often sold in $1,000 increments with a $5,000 minimum but that isn’t true with all bonds. (Savings bonds, for example) Bonds are not nearly as liquid as stocks and still have to go through trading desks often pushing the commission up.

  4. If you’re smart and buy individual bonds below par you can make a profit above and beyond interest alone when the bonds are redeemed. With the low interest rate environment that we are in now (which punishes savers and rewards borrowers), finding bonds trading below par is difficult to do unless you are willing to buy issues like BAC and some other financials.

  5. timparker says:

    Correct, Biz. The only pushback I would give to you is that most individual investors don’t have enough capital to diversify their portfolio with individual bonds and realistically, quality bonds, as you said, aren’t going to sell that far below par unless the risk is greatly ratcheted up. If you want financials, go with the BAC or Wells Fargo preferreds instead.

    • The bond market is going to get very ugly sometime in the not too distant future when interest rates inevitably start rising (probably after the Presidential election). Buying below par is an investors only protection. ETFs might provide diversity, but they are portfolios filled with bonds selling above par which guarantees some loss of principle at redemption. Preferreds are a higher yielding income alternative to bonds, but the same rules apply. Always buy below par and make sure they are cumulative preferreds. The disadvantage with perferreds, besides more volatility than bonds, is that you don’t when the issuer will redeem. Most issues have options to redeem anytime they feel like it 5 years after issue.


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