Bonds are newer to the ETF playing field than equities; the first fixed-income ETF didn't launch until 2002. But while they may have gotten off to a slower start than their equity-based cousins, the bond ETF universe exploded in 2009. The sector netted $44.8 billion in new investment—the most of any asset class that year—and in the first quarter of 2010, total assets under management in the fixed-income space have swelled to over $116 billion.1
Perhaps it's no surprise that, in the wake of the 2008 market meltdown, investors increasingly sought to bulk up their fixed-income allocations as a buffer against the shaky economic recovery. Bond ETFs offer diversity and safety in one convenient and affordable package, and their appeal has outlasted the crisis-inspired flight to safety.
Making the Bond Market More Transparent
In some ways, the ETF structure is even more advantageous for fixed-income exposure than for equities, because it imposes a heretofore unseen level of transparency on the bond market.
Stock prices are widely reported and are easy for investors to find. Bond prices, however, are more opaque, as most issues trade over-the-counter. The individual prices and quantities involved in these transactions are not always readily available, making it hard for investors to be sure they've gotten a good deal.
ETFs, on the other hand, must publish the value of their holdings every day, which means that bond ETF investors will always have access to what their fund has traded and for what price.
Of course, the nature of bonds does pose some challenges for ETF construction. Bonds tend to lack liquidity, transparency and trading flexibility, all of which can raise the cost of trades and can lead to wide swings in premiums and discounts for non-Treasury bond ETFs.
In addition, bond indexes can sometimes contain hundreds, if not thousands, of individual issues. Given the illiquidity of the underlying bond market, many ETF providers are forced to use optimization strategies (as discussed in our "How to Evaluate an ETF" article) in an attempt to replicate the return of the index, raising the likelihood of tracking error.
Unlike bonds themselves, ETFs don't carry a maturity date; when the individual issues within a portfolio expire, the principal is immediately reinvested into new bonds. This means that most bond ETFs never “mature,” and investors are subject to ongoing interest-rate risk. Recently, firms have launched bond ETFs that are designed to mature and be liquidated at fixed dates in the future.
The Bond ETF Universe
More than 100 fixed-income ETFs now exist, from broad-based total market funds to narrow targeted maturity date municipal bond ETFs, giving investors more options for exchange-traded access than ever before.
Still, most of the assets in the bond ETF space remain concentrated in total market funds, the two largest being the iShares Barclays Aggregate Bond Fund (NYSEArca: AGG) and the Vanguard Total Bond Market ETF (NYSEArca: BND). These two funds, together worth $18.6 billion, are both linked to the Barclays Capital U.S. Aggregate Bond Index, the benchmark for U.S. investment-grade bonds.
Other popular categories of bond ETFs include:
- Corporate debt, from investment-grade to junk bonds
- Municipal bonds
- Mortgage-backed securities
- Emerging market debt
Fixed-income ETFs are still evolving, and in fact, this may be the first ETF space where active management takes off. The liquidity issues surrounding bonds and bond indexes make optimization and other more active approaches more appealing, and several active bond ETFs have either launched or are in the works.
 Data courtesy NSX Stock Exchange, current as of March 31, 2010
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