Why Bond ETF's May Not Be Your Best Choice

Matt Thalman - INO.com Contributor - ETFs

One of the greatest things about the world of finance is we have so many different options when it comes to investing. We have stocks, bonds, mutual funds, ETF's, real estate, commodities, metals, currency, the list goes on. But, with all of these different options, it is difficult to navigate through what we should be investing in and what we should leave alone. Each of the different options investors have at their disposal has their own pros and cons.

With that in mind, let's take a look at Bond Exchange Traded Fund's to help determine if they are the best option for you.

Issues with Bond ETF's

First what is a bond ETF? Similar to other ETF's it is a highly liquid asset which investors can trade in and out of daily, hourly, or even by the minute. These funds hold a variety of different "bond's", based on the restrictions the fund manager has set for the ETF. For example the Pimco Total Return Active ETF (BOND) states its own restrictions as following;

"The fund invests under normal circumstances at least 65% of its asset in a diversified portfolio of Fixed Income Instruments of varying maturities, which may be represented by forwards or derivatives such as options, futures contracts, or swap agreements. It invests primarily in investment-grade debt securities, but may invest up to 10% of its total assets in high yield securities ("junk bonds") rated B or higher."

This essentially means the fund manager can buy whatever he/she wants as long as it falls under one of the categories mentioned above. (This is common among ETF's and mutual funds.) But, if you really read what the manager can purchase, in this case it's just not investment grade bonds, but options, derivatives, futures and even 10% of the funds' assets can be in "junk bonds"; all investments which most would consider much riskier than your investment grade bond.

Furthermore, while this particular bond ETF doesn’t have an unreasonably high expense ratio, just 0.56%, (that is what you are paying to own the fund, plus commission to your broker when you trade in and out of it) the fund has an annual holdings turnover of 577%. A 100% turnover would mean all of the assets the fund holds at the start of the year were sold and new ones were purchased before the year ended.

A 577% turnover means all of the holdings were sold and new ones were purchased nearly six times throughout just one year. This matters to investors because short term capital gains taxes are being paid by the fund each time an asset is sold and commissions are paid both when a sale and purchase is made. The ETF investor may not actually see these costs, but they are certainly eating into the funds overall assets (cash on hand) and hurting its performance.

Now, not all bond ETF's are quite this high; the Vanguard Total Bond Market ETF (BND) has annual holdings turnover of 73%, carries an annual expense ratio of just 0.08%, and attempts to mimic the performance of the Barclays U.S. Aggregate Float Adjusted Index, (which is a bond index).

On the performance front, both ETF's mentioned above are up about 3.5% over the past year, and the Pimco ETF has 4.12% yield while the Vanguard ETF carries 2.5% yield. Not mind blowing performance, but remember these are bond funds.

But there is one more big issue to worry about. When bonds are being traded on the open market they are valued based on what their individual yield is and what brand new bonds are yielding. Currently we are in a very low interest rate-yield environment. When rates begin to move higher and new bonds begin to yield more, the older bonds will trade for less on the open market,(because who wants a bond yielding 3% when you can have one yielding 5%) which in turn will hurt the value of bond funds. Furthermore, when interest rates begin to rise it is likely that even fund's that have had low turnover in the past will see much higher turnover as the managers search for higher yielding investments.

Benefits of Bond ETF's

So what's the benefit of a bond ETF? In the short-term, the ETF is a safe place to park a little cash while you wait for better opportunities in the future. The ease of getting into and out of the ETF is great. Also, safety of bonds in the short term combined with the layering effect, since the ETF owns a number of bonds, is ideal for someone looking to preserve capital. Lastly, the decent yield is in most cases at least the same if not better than what other investments will be paying.

Overall Conclusion

Holding a bond ETF for a long period of time will only cost you money through fees and the fund itself using capital when it constantly is buying and selling. Furthermore, even if you do your due diligence the bond fund may being trading assets that are much riskier than that of what you are comfortable with owning.

If you are a long-term investor, looking to preserve capital through owning bonds, your best bet will be simply buy bonds directly and hold them until maturity. Find a blue-chip company offering a bond with a reasonable yield and for a reasonable time period; buy the bond and be content.

Matt Thalman
INO.com Contributor - ETFs

Disclosure: This contributor has no positions in any stocks mentioned in this article at the time it was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.