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.
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.