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Bond mutual funds (sometimes known simply as bond funds) and bond ETFs (or exchange-traded funds) both feature a basket of bonds or other debt instruments – but there are some key differences that investors should be aware of.

Bond funds are mutual funds that pool capital from investors, from which a fund manager allocates that capital to various fixed-income securities. A bond ETF instead tracks an index of bonds with the goal of matching the returns from the underlying index.

Bond funds and bond ETFs share several characteristics, including diversification via portfolios that hold numerous bonds. Both funds and ETFs have smaller minimum required investments that would be necessary to achieve the same level of diversification by purchasing individual bonds in constructing a portfolio.

Before comparing bond funds and bond ETFs, it is worth taking a few moments to review the reasons why investors buy bonds. Most investors put bonds in a portfolio to generate income. A bond is a debt instrument that typically pays an interest rate, called a coupon rate each year to the bondholder. Although buying and selling bonds to generate a profit from fluctuations in their prices is a viable strategy, most investors invest in them for their interest payments.

Investors also buy bonds for risk-related reasons, as they seek to store their money in an investment that is less volatile than stocks. Volatility is the extent to which a security’s price fluctuates over time.

Both bond funds and bond ETFs can pay dividends, which are cash payments from companies for investing in their securities. Both types of funds offer a wide variety of investment choices ranging from high-quality government bonds to low-quality corporate bonds and everything in between.

Both funds and ETFs can also be purchased and sold through a brokerage account in exchange for a small per-trade fee. Despite these similarities, bond funds and bond ETFs have unique, unshared characteristics.

Bond Funds

Mutual funds have been investing in bonds for many years. Some of the oldest balanced funds, which include allocations to both stock and bonds, date back to the late 1920s.

Accordingly, a large number of bond funds in existence offer a significant variety of investment options. These include both index funds, which seek to replicate various benchmarks and make no effort to outperform those benchmarks, and actively managed funds, which seek to beat their benchmarks.

Actively managed funds also employ credit analysts to conduct research into the credit quality of the bonds the fund purchases to minimize the risk of purchasing bonds that are likely to default. Default occurs when the issuer of the bond is unable to make interest payments or pay back the original amount invested due to financial difficulty. Each bond is assigned a credit quality grade by credit rating agencies that assess the financial viability of the issuer and the likelihood of default.

Bond funds are available in two different structures: open-ended funds and closed-end funds. Open-ended funds can be bought directly from fund providers, which means they do not need to be purchased through a brokerage account. If purchased directly, the brokerage commission fee can be avoided. Similarly, bond funds can be sold back to the fund company that issued the shares, making them highly liquid or easily bought and sold.

In addition, open-ended funds are priced and traded once a day, after the market closes and each fund’s net asset value (NAV) is determined. The trading price is a direct reflection of the NAV, which is based on the value of the bonds in the portfolio.

Open-ended funds do not trade at a premium or a discount, making it easy and predictable to determine precisely how much a fund’s shares will generate if sold. A bond sold at a premium has a higher market price than its original face value amount while a discount is when a bond is trading at a lower price than its face value.

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Notably, some bond funds charge an extra fee if they are sold prior to a certain minimum required holding period (often 90 days), as the fund company wishes to minimize the expenses associated with frequent trading.

Bond funds do not reveal their underlying holdings on a daily basis. They generally release holdings on a semi-annual basis, with some funds reporting monthly. The lack of transparency makes it difficult for investors to determine the precise composition of their portfolios at any given time.

Bond ETFs

Bond ETFs are a far newer entrant to the market when compared to mutual funds, with iShares launching the first bond ETF in 2002. Most of these offerings seek to replicate various bond indices, although a growing number of actively managed products are also available. Because of their passive approach, ETFs often have lower fees than their mutual fund counterparts, potentially making them the more attractive choice to some investors all else being equal.

Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company. Likewise, when an investor wishes to sell, ETFs must be traded on the open market, meaning that a buyer must be found because the fund company will not purchase the shares as they would for open-ended mutual funds.

Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of trading. Extremes in price fluctuation have been seen during market anomalies, such as the so-called Flash Crash of 2010. Shares can also trade at a premium or a discount to the underlying net asset value of the holdings.

While significant deviations in value are relatively infrequent, they are not impossible. Deviations may be of particular concern during crisis periods, for example, if a large number of investors are seeking to sell bonds. In such events, an ETF’s price may reflect a discount to NAV because the ETF provider is not certain that existing holdings could be sold at their current stated net asset value.

Bond ETFs usually do not have a minimum required holding period, meaning that there is usually no penalty imposed for selling rapidly after making a purchase. Keep in mind there may be restrictions on then withdrawing the proceeds based on how that bond ETF is being held. For example, holding a bond ETF within a retirement vehicle may limit when those funds can be accessed without penalty fees or taxes (even though you can still sell).

They can also be bought on margin and sold short, offering significantly greater flexibility in terms of trading than open-ended mutual funds. Margin involves borrowing money or securities from a broker to invest. Also, unlike mutual funds, bond ETFs reveal their underlying holdings on a daily basis, giving investors complete transparency.

The Difference Between Bonds and Bond ETFs 

The main difference between bonds and bond ETFs is how they are structured. For example, when investors buy individual bonds, they are purchasing a specific debt security issued by a government, municipality or corporation. Whereas bond ETFs are structured like mutual funds but are traded on an exchange throughout the day.  

This difference in structure brings about other differences, including diversification, liquidity and income distribution. 

Differences between bonds and bond ETFs include: 

  • Diversification: Investors in individual bonds hold a specific bond issued by a single entity. Bond ETFs offer diversification by holding a portfolio of bonds, meaning ETF investors indirectly own a fraction of each bond in the portfolio, providing exposure to a variety of issuers and maturities. 
  • Liquidity: The liquidity of individual bonds depends on factors such as the specific bond’s issuance size, credit rating and prevailing market conditions. Traded on stock exchanges, bond ETFs provide intraday liquidity, allowing investors to buy or sell shares throughout the trading day at market prices. 
  • Income distribution: With individual bonds, investors typically receive semiannual or annual interest payments directly from the issuer, and they may receive the face value of the bond at maturity. With bond ETFs, investors typically receive monthly income distributions in the form of dividends originating from the interest payments made by the bonds in the ETF’s portfolio. 
  • Maturity: Individual bonds have a fixed, unchanging date at which they mature, and investors get their money back; each day invested is one day closer to that result. Bond ETFs do not mature and typically attempt to maintain a weighted average maturity or duration. As a result, additional bonds are continually being bought and sold to keep the portfolio’s maturity constant.  
  • Minimum investment: Purchasing individual bonds typically requires a larger initial investment, often in increments of the face value of the bond. Investors can buy shares of bond ETFs with a relatively small investment, as they are priced based on the market value of the ETF. 
  • Management: Investors who hold individual bonds are responsible for managing their bond portfolio, including selecting bonds, monitoring credit risk and reinvesting as bonds mature. Bond ETFs can be passively managed, tracking a specific bond index, or actively managed by professional portfolio managers who make strategic decisions about the portfolio composition. 
  • Market price vs. face value: The market price of an individual bond can fluctuate, but it is typically influenced by changes in interest rates and the creditworthiness of the issuer. If an investor holds an individual bond until maturity, however, he or she will receive the face value. The market price of a bond ETF is determined by supply and demand in the secondary market. It may trade at a premium or discount to its net asset value, or NAV. 

Bonds and bond ETFs have similar and unique advantages for investors to consider before choosing which is better for their investments needs. 

Advantages of Investing in Bonds 

  • Regular income: Bonds typically pay periodic interest payments, known as coupons, to bondholders. This provides a predictable and regular stream of income, making bonds attractive for income-focused investors, retirees and those seeking cash flow. 
  • Capital preservation: The return of principal is a key feature of bonds, especially if the bond is held until maturity. This makes bonds a potentially less risky investment compared to stocks and some bond ETFs. 
  • Stability in turbulent markets: During periods of market volatility or economic uncertainty, bonds often act as a safe-haven asset, especially government bonds, which are considered low-risk investments and tend to attract investors seeking stability. 
  • Risk management: Different types of bonds carry different risk profiles. By carefully selecting bonds based on credit quality, maturity, interest rate risk and other factors, investors can tailor their bond investments to manage specific risks within their portfolio. 
  • Tax advantages: Certain types of bonds, such as municipal bonds, may offer tax advantages. Interest income from municipal bonds is often exempt from federal income taxes, and in some cases, state and local taxes, providing tax-efficient income. 

Advantages of Investing in Bond ETFs 

  • Diversification: Bond ETFs provide instant diversification by holding a portfolio of bonds that can be diversified across risk across different issuers, maturities and sectors. Investors gain exposure to a broad range of bonds without having to purchase individual securities. 
  • Liquidity: Trading like stocks on an exchange, bond ETFs provide investors with intraday liquidity, allowing them to buy or sell shares throughout the trading day at market prices. The ability to trade ETFs on an exchange enhances liquidity compared to traditional mutual funds. 
  • Accessibility: Bond ETFs can be bought and sold through brokerage accounts, making them accessible to a wide range of investors with varying levels of investment capital. 
  • Lower investment minimums: Investing in a bond ETF requires a lower minimum investment compared with building a diversified portfolio of individual bonds. 
  • Professional management: Bond ETFs can be passively managed or actively managed by professional portfolio managers. This can be beneficial for investors who prefer a hands-off approach to managing their fixed-income investments. 
  • Income generation: Bond ETFs typically produce regular distributions, often in the form of monthly dividends, providing a consistent income stream that can be attractive for income-oriented investors. 
  • Cost efficiency: Bond ETFs often have lower expense ratios compared to actively managed bond mutual funds. The efficiency of the ETF structure allows for cost savings, contributing to a more cost-effective investment option for investors. 
  • Potential tax efficiency: Bond ETFs may be more tax-efficient than certain actively managed bond funds. The “in-kind” creation and redemption process of ETFs can help minimize capital gains distributions, potentially offering tax advantages for investors. 
  • Intraday pricing: Unlike traditional mutual funds, which are priced at the end of the trading day, bond ETFs are priced and traded throughout the day. This intraday pricing allows investors to react to market conditions and news events in real-time. 
  • Options trading: Some bond ETFs have options traded on them, providing additional strategies for investors to manage risk or enhance returns through options trading. 

While bonds and bond ETFs each offer investors multiple benefits, there are potential risks and other disadvantages that investors should understand before choosing between the two. 

Disadvantages of Investing in Bonds 

  • Interest rate risk: Bond prices are inversely related to interest rates. When interest rates rise, bond prices tend to fall, and vice versa. This interest rate risk can result in capital losses for bondholders, especially if they need to sell bonds before maturity. 
  • Credit risk: Also known as default risk, credit risk is the risk that the issuer of a bond may fail to make interest payments or repay the principal at maturity. Bonds with lower credit ratings generally offer higher yields but come with increased credit risk. 
  • Inflation risk: Inflation erodes the purchasing power of money over time. Fixed-rate bonds may not keep pace with inflation, meaning that the real (inflation-adjusted) return on investment may be lower than expected. 
  • Reinvestment risk: When interest rates fall, investors may face reinvestment risk. This occurs when maturing bonds are reinvested at lower interest rates, potentially reducing the overall income generated by the bond portfolio. 
  • Liquidity risk: Some bonds, especially those with less frequent trading, may lack liquidity in the secondary market. Investors may face challenges selling these bonds at desired prices, especially during periods of market stress. 
  • Market risk: The overall performance of the bond market can be influenced by macroeconomic factors, geopolitical events and changes in investor sentiment. Market risk can affect the value of a bond portfolio. 
  • Call risk: Callable bonds give issuers the option to redeem the bonds before maturity. If interest rates decline, issuers may choose to call and refinance their debt at lower rates, leading to the early retirement of higher-yielding bonds and potential reinvestment challenges for bondholders. 
  • Currency risk (for international bonds): Investors in bonds denominated in foreign currencies face currency risk. Fluctuations in exchange rates can affect the returns earned by investors when converted back to their home currency. 
  • Economic and industry risks (for corporate bonds): Corporate bonds are subject to economic and industry-specific risks. A company’s financial health, business model and industry conditions can affect the performance of corporate bonds. 
  • Complexity: Bond investing requires careful consideration of various factors, including credit quality, duration and yield. Investors may find it challenging to navigate the complexities of the bond market and select suitable securities. 
  • Tax implications: Depending on the investor’s tax situation and the type of bonds held, interest income may be subject to federal, state and local taxes. Tax considerations can affect the after-tax return on bond investments. 
  • Limited performance: While bonds provide regular income through interest payments, they may have limited capital appreciation potential compared with some other investments like stocks. Investors seeking significant capital gains may find other asset classes more suitable. 

Disadvantages of Investing in Bond ETFs 

  • Interest rate risk: Like individual bonds, Bond ETFs are subject to interest rate risk. When interest rates rise, bond prices typically fall, and this can lead to capital losses for investors in bond ETFs. The degree of interest rate risk depends on the duration of the bonds held in the ETF’s portfolio. 
  • Credit risk: Bond ETFs hold a portfolio of bonds, and the credit quality of these bonds can vary. If the ETF holds bonds with lower credit ratings, it may be exposed to higher credit risk. Defaults or downgrades of the underlying bonds can have an impact on the ETF’s performance. 
  • Market price vs. net asset value: The market price of a bond ETF can deviate from its net asset value. While the creation and redemption mechanism in ETFs helps keep prices close to NAV, during periods of market stress or illiquidity, the market price may temporarily diverge. 
  • Tracking error: The performance of a bond ETF may not perfectly replicate the performance of the index it aims to track. Factors such as transaction costs, management fees and the timing of trades can contribute to tracking error. 
  • Intraday price volatility: Bond ETFs are traded on stock exchanges, and their prices can be subject to intraday volatility. That can be more pronounced during periods of market stress, and investors may experience price fluctuations even if the value of the underlying bonds remains relatively stable. 
  • Premiums and discounts: Bond ETFs may trade at a premium or discount to their NAV. This can occur due to supply and demand factors, liquidity issues in the bond market, or market sentiment. Investors may face the risk of buying at a premium or selling at a discount, especially in an ETF with low assets under management and low trading volume. 
  • Market conditions affect returns: Bond ETF returns are influenced by market conditions, including interest rates and credit spreads. In certain market environments, such as rising interest rate environments or economic downturns, bond ETF returns may be affected. 

Bottom Line

Finally, the choice between individual bonds and bond ETFs is based on your personal tastes, investing plan, and financial situation. While there are major distinctions to consider, bonds and bond ETFs have many characteristics, including as income creation and suitability for conservative strategies. Some investors may find that combining the two methodologies is appropriate for their overall fixed-income portfolio.

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