Schlanger: The advantages of using bond ETFs over individual bonds

  • Bond exchange-traded funds (ETFs) can offer significant advantages compared with building a portfolio of individual bonds.
  • These advantages can include greater diversification, liquidity and transparency, easier reinvestment of capital and income, and more consistent risk characteristics.
  • Bond ETFs also tend to be lower cost, which can have a large impact on net returns, particularly in a low-yield environment.

For most investors, bond ETFs offer advantages over individual bonds.1

These advantages can include greater diversification, easier reinvestment of capital and income, and more consistent risk characteristics. In addition, bond ETFs tend to be lower cost for most investors which, all else being equal, should translate into higher net returns.

Portfolios of individual bonds also have their advantages, but most of them relate to control over security-specific decisions and tend to come with an associated “control premium.”2

Advantages of bond ETFs

Diversification. Global investment-grade fixed income markets play an important role in investment portfolios as a stabilizing force to diversify riskier investments such as equities.

Access to a well-diversified portfolio of bonds is one of the key advantages to owning a bond ETF, as is increased simplicity and ease of use. Through a single holding in a bond ETF, investors can access hundreds if not thousands of bonds that are diversified among issuers, credit quality and term structure.

Building such a portfolio takes the size and scale provided by a large portfolio, such as an ETF.

Low costs. In the current low-yield environment, investing costs matter more than ever. This is especially true for bond markets, where yields are below their historical averages and costs erode a larger share of returns than they have in the past. All else being equal, lower costs should translate into higher net returns and better performance.

Bond ETFs tend to have greater economies of scale than most individual bond portfolios built by advisors. This size advantage should generally translate into lower execution costs.

ETFs also tend to have greater bargaining power than investors trading in smaller sizes because they have access to a larger number of dealers and counterparties. This access can translate into more favourable pricing.

Liquidity and transparency. Bond ETFs can be traded at any time during market hours, making them more liquid than individual bonds. They also have more transparency on pricing and what investors are bidding and asking. Data on duration, credit ratings and yield are also readily available for ETFs.

Ease of capital and income reinvestment. Compared with individual bonds, bond ETFs provide more timely investment of initial principal and periodic income cash flow.

Consistent risk characteristics. Bond ETFs provide more consistent risk characteristics (such as portfolio duration) than individual bonds, making liquidations, especially partial liquidations, much easier.

Advantages of individual bonds

Portfolios of individual bonds can also have their advantages. Ironically, one commonly cited reason for using them— greater protection from rising interest rates—is not among their advantages.

This is because when the principal paid at maturity is reinvested, as it often is in laddered individual bond strategies, the resulting portfolio is functionally similar to a pooled fund, such as an ETF.

Instead, the advantages of using a portfolio of individual bonds relate to control over security-specific decisions and tend to come with an associated “control premium,” which is reflected in generally higher transaction costs, lower liquidity and a higher overall portfolio risk. This premium tends to be more pronounced for buyers of corporate bonds and mortgage-backed securities than for buyers of government bonds.

Low-cost bond ETFs can add value to client portfolios

Bond ETFs hold a number of advantages over individual bond portfolios in terms of diversification, cost, liquidity, transparency, more consistent risk characteristics, and cash flow treatment along with the expertise of an investment management team.

Low-cost and diversified ETFs provide building blocks that can help advisors when setting and maintaining their clients’ overall asset allocation strategies.

1 This research note focuses on the advantages of using bond ETFs over individual bonds. The risks and benefits of owning bonds as an asset class are generally beyond the scope of this note.

2 The control premium refers to generally higher (or additional) transaction costs, lower liquidity, more limited return opportunities, and higher bond portfolio risk.

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