Bond ETFs are gaining investor attention. What to know before you buy

If you’re thinking about putting money into bond exchange traded funds (ETFs) rather than mutual funds, you’re not alone.

Fixed-income ETFs have pulled in nearly $344 billion through Oct. 31 this year, compared with $138 billion going into fixed income mutual funds, according to Morningstar Direct. It’s part of the larger trend of investors preferring ETFs: In October alone, about $74 billion flowed out of mutual funds, while ETFs attracted $166 billion.

And while ETFs have some advantages over mutual funds, and bonds are viewed as safer investments than stocks, experts say it’s important to know what you’re buying.

“You have to remember the role of bonds in a portfolio,” said Dan Sotiroff, senior analyst for passive strategies research at Morningstar. “It’s usually to serve as a ballast — and how big of one is something you have to sort out on your own or with your advisor.”

‘Legitimate edge’

Both mutual funds and ETFs let you invest in a fund that holds a mix of underlying investments. The advantages of ETFs range from lower costs to tax efficiency to their trading all day in the open market. (Mutual funds are only priced once a day, after the markets close at 4 p.m. Eastern Time.)

One reason for assets flowing to bond ETFs is simply that more have been launched in recent years, especially those that are actively managed — meaning professionals are choosing which bonds to invest in — which previously was the sole province of bond mutual funds. In contrast, passively-managed ETFs track an index, and their performance mimics that benchmark, for better or worse.

“Active management has a legitimate edge,” Sotiroff said. Managers there “can bring something different to the equation and have a shot at outperforming their benchmark.” 

The number of actively managed bond ETFs (511) has surpassed the number of passive bond ETFs (393), according to Morningstar.

The active funds come with higher expense ratios — the yearly fees paid by investors, expressed as a percentage of the fund’s total assets. Investors pay an average of 0.35% for actively managed bond ETFs, versus 0.10% for passively managed bond funds.

Know what bonds you’re buying

Also remember that because bonds pay interest, those ETFs distribute monthly payments to investors, who face taxes on that income if the ETFs are held in a taxable brokerage account. If they are in an individual retirement account or 401(k) account, any growth is tax-deferred and then subject to ordinary income tax rates when money is withdrawn after age 59½. If they’re held in a Roth IRA account, withdrawals are tax-free.

And whether you consider passive or active bond ETFs, it’s important to consider the type of bonds you’re investing in, experts say. For example, U.S. Treasurys and corporate bonds with solid credit ratings are considered investment-grade, meaning that there’s less risk of default.

“The correlation with stocks is really low and that’s important to keep in mind” when seeking to diversify, Sotiroff said.

Investment-grade bonds tend to generate less income than riskier bonds, while high-yield corporate bonds with lower investment ratings may offer higher yields but come with a greater chance of default.

If you are relying on bonds for income in retirement, trying to squeeze too much income out of your bond portfolio could end up backfiring.

Bond ETFs “are basically funding our clients’ living expenses, so we need to be liquid and high quality,” said certified financial planner Tim Videnka, chief investment officer and principal with Forza Wealth Management in Sarasota, Florida.

Bonds lose money, too

But as with all investments, bonds can lose money, too, Videnka said.

In 2022, as the Federal Reserve began raising its benchmark interest rate to fight high inflation, bond prices slumped (prices move inversely to yield), and the year ended as the worst ever bonds, with major bond indexes posting large losses.

The year 2022 “showed you can lose money in the bond market,” said Videnka. “People can sometimes forget what can happen when there’s real fear.”

One reason bond prices fall when rates rise is because newly-issued debt comes with higher interest rates, making existing bonds with lower rates less valuable — pushing down their price.

Although the Federal Reserve lowered its benchmark interest rate — the federal funds rate — in October for the second time this year, it remains far higher than was the case for years before the Fed started raising rates in 2022. The fed funds rate is the rate that commercial banks charge one another for overnight borrowings to meet reserve requirements, and it ripples through the economy, affecting the rate charged for mortgages, auto loans and credit card debt as well as the interest rate on bonds and savings accounts.

“If you go back 15 years ago, after the [2008-2009] financial crisis, we were in a 0% rate environment and then Covid hit and we had another 0% rate environment,” Sotiroff said.

“Now you actually have [positive] interest rates … you have some returns that make bond ETFs attractive,” he said.