Exchange traded bond funds
What are bonds?
Bonds are fixed interest earning financial instruments issued by governments or business enterprises.
How are they different from shares?
Major differences between shares and bonds are:
a. Shares do not carry any fixed income, sometimes the dividends may be higher, and sometimes there may be no dividend at all.
b. Shares are risky investments because they are not secured. Unlike shares, bonds are secured instruments; therefore, in case a business enterprise files a bankruptcy case, repayment of bond takes priority over repayment of share cost.
c. Shares can be speculated on based on anticipated receipts on any contracts, or prospects. Because bonds have predefined interest rates, such speculation is negligible.
When do bonds command a premium?
Bonds do command premium when inflation is low, interest rates are low and economies are weak. Suppose a bond is purchased in 2007. The term is 5 years and interest rate it carries is 9 percent. 2 years down the lane, that is in 2009, due to some circumstances, the economy starts hiccupping, federal bank starts lowering interest rates to as low as 1 percent, inflation too is not to be seen. Obviously, the balance 8 percent would seem very good return. Especially since, in such scenario, stock markets register a negative growth.
What are Exchange Traded Funds?
Exchange Traded Funds (ETFs) are new type of financial instruments that combine the benefits of shares with mutual fund units. Therefore, like shares, they can be traded on stock exchanges, and carry less transaction and brokerage charges. Like mutual funds, they are diversified and managed by professionals. The additional benefit of ETFs is that, it gives a new approach to trading on stock markets. Earlier, it was not possible to trade commodities like gold, oil, silver, currencies, agricultural produce, etc., on stock markets. Through ETFs, it is possible to trade in such commodities. In addition, ETFs have also opened bond markets to stock market investors.
Why would a stock market investor be interested in bond market instrument?
Prima facie, it does not make sense, because equities offer good returns. But, an investor seeking to diversify his or her portfolio would look at options available. After all, there are some equities in market that offer lesser returns than the bonds. Therefore, the bonds will command higher premium when compared to such equities.
Bonds also offer more stability than shares, and are therefore a better investment option for retirement planning.
Do returns on Exchange Traded Bond Funds or Bond ETFs equal the returns on Bonds?
Not really. Investing and earning on bonds directly does not entail any brokerage, transaction or professional management charges.
Then why opt for Bond ETF, when investing in bonds is cheaper?
Investing in Bond ETFs is better than investing in bonds because it is easier for stock market investors to switch from one level of returns to another through ETFs. Therefore, investor looking at a return of 4 or 5 percent would be willing to pay slight premium on Bonds that give 9 percent.
Unlike Bond ETFs, the premium in bond market would be limited because of fewer participants.
In addition, bonds have to be held for the entire term, i.e., 1 year, or 2 years, or 3 years or so on, before receiving back thefunds. Bond ETFs do not have any such restriction.
Dividend distribution in Bond ETFs
Income received as interest is passed on to the investors on monthly basis, after deducting the charges, as applicable. Capital gains are extremely rare. If such gains materialize, then they are passed on to investors as annual dividend after deducting any management and other charges.
Index selection
There are many indexes of bonds that give an idea about how much can be made out of bond investments.
Some of the famous bond indexes are Lehman Brothers Treasury Bond Indexes, Goldman Sachs InvesTop Corporate Bond Index, and Lehman Aggregate Bond Index.
It is not essential that a fund manager invest in each and every bond of the index list. For example Lehman Aggregate Bond Index has over 6000 bonds in it. Funds required to invest in each of these bonds would be substantial. Therefore, fund issuers select a set of bonds from this list, which they feel will fetch them the rate of return that the index would generate overall.
Income selection
Unlike standard ETFs, which bring in versatility in the stock markets with their permutations and combinations of the industries, indexes, and commodities, Bond ETFs do not offer much variety. However, income ranges of Bond ETFs are generally defined. This helps the investor in selecting the level of monthly income, and the level of growth.
Some of the popular Bond ETFs
Barclays Group of Investors has come up with maximum number of bond ETFs.
Broadly, these ETFs can be divided into two categories, the corporate bond ETFs, and the government bond ETFs.
Government bond ETFs:
iShares Lehman 1-3 year Treasury Bond Fund (SHY)
iShares Lehman 3-7 Year Treasury Bond Fund (IEI)
iShares Lehman 7-10 Year Treasury Bond Fund (IEF)
iShares Lehman 10-20 year Treasury Bond Fund (TLH)
iShares Lehman 20+ Year Treasury Bond Fund (TLT)
iShares Lehman Government/Credit Bond Fund (GBF)
iShares Lehman Intermediate Government/Credit Bond Fund (GVI)
Corporate bonds:
iShares iBoxx US Dollar Investment Grade Corporate Bond Fund (LQD)
iShares Lehman 1-3 Year Credit Bond Fund (CSJ)
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