Bond ETFs: everything you need to know

Bond ETFs are ideal for creating a stable source of income with broad risk diversification. They combine the security of traditional bonds with the flexibility of exchange-traded funds, offering a balanced mix of safety, yield and liquidity.

In this article, discover what bond ETFs are, how they work, their advantages and disadvantages, and whether they can meaningfully complement your financial strategy.

• Bond ETFs invest in a diversified portfolio of government or corporate bonds, providing a stable income source through regular interest payments

• Unlike individual bonds, bond ETFs are flexibly tradable on stock exchanges and do not have a fixed maturity date

• Investors can choose between distributing bond ETFs (regular interest payouts) and accumulating bond ETFs (reinvestment of returns)

• Bond ETFs are particularly suitable for investors seeking a combination of stability, diversification, and regular income in their portfolios

What are bond ETFs?

Bond ETFs, also known as bond exchange-traded funds, provide investors with access to a diversified portfolio of government or corporate bonds. By spreading investments across many bonds, risks can be reduced.

Unlike traditional bonds, which are purchased directly by investors and held until maturity, bond ETFs allow for flexible trading on stock exchanges. They typically track a specific bond index to replicate its performance. Through regular interest payments, they can serve as a source of income, while the ETF’s price movements can further influence returns. This makes them an attractive option for investors seeking both stability and income.

Bond ETFs also offer retail investors an easy entry point into the bond market, as they do not require high minimum investments compared to individual bonds.

How do bond ETFs work?

Bond ETFs pool investors’ capital to invest in a variety of bonds that may have different characteristics depending on the fund. These may include government bonds, corporate bonds or specialised fixed-income ETFs that focus on stable interest income. The composition of the ETF typically mirrors a specific bond index, aiming to closely replicate its performance.

A bond ETF generates returns primarily from the interest regularly paid by the bonds it holds. Depending on the ETF, these returns can either be distributed or reinvested. Another feature is the continuous adjustment of the portfolio. As bonds mature or new ones are added to the index, the fund adjusts its composition accordingly. This ensures the ETF remains invested over the long term and delivers consistent performance aligned with the underlying index.

Investors benefit from the tradability of bond ETFs on stock exchanges, making them easy and flexible to buy or sell. However, the price of a bond ETF is subject to fluctuations, influenced by changes in interest rates or the creditworthiness of the issuers (such as governments or corporations) of the underlying bonds.

The difference between bond ETFs and individual bonds

Bond ETFs bundle numerous bonds into a single fund, replicating a specific index, while individual bonds are purchased directly from issuers and have a fixed maturity. A key difference is that bond ETFs do not offer a repayment of the principal at a set date, whereas individual bonds guarantee full repayment at the end of their term, provided the issuer remains solvent.

Individual bonds provide predictable income and the security of repayment at a fixed date. In contrast, bond ETFs continuously reinvest capital into new bonds, leading to a perpetual investment without a fixed term.

Bond ETFs enable broad diversification, spreading risk, and are flexibly tradable on stock exchanges. Individual bonds often require higher minimum investments, offer less diversification, and are less liquid. The choice between the two depends on individual goals and risk tolerance. Compared to equities, bond ETFs offer more stability, making them particularly attractive for investors who prioritise a balanced portfolio.

When are bond ETFs appropriate?

Bond ETFs are especially suitable for investors seeking a balance between stability and returns in their portfolios. They are particularly appealing during periods of low interest rates as an alternative to fixed-term or savings accounts, offering regular income alongside broad diversification.

Additionally, bond ETFs are advantageous for investors who value flexibility, as they can be traded on stock exchanges at any time. They are ideal for long-term investors aiming for ongoing interest payments or continuous growth in value. Bond ETFs can also serve as a valuable tool for risk diversification when combined with equities or other asset classes, reducing portfolio volatility and benefiting from the stable performance of various bond and equity markets over the long term.

Whether bond ETFs are worthwhile depends on individual goals, risk tolerance, and investment horizon. Investors seeking a cost-effective and liquid way to access the bond market can benefit from the advantages of these funds.

Risk and return with bond ETFs

Bond ETFs are considered stable investment options with predictable income. Their returns are derived from the regular interest payments of the bonds they hold, which vary depending on the maturity and credit quality of the issuers. While government bond ETFs often offer lower returns with high security, corporate bond ETFs can provide higher yields, depending on the creditworthiness of the underlying companies.

However, bond ETFs are sensitive to interest rate changes: rising interest rates can lead to falling bond prices. Broad diversification within an ETF can help mitigate this risk.

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What should I consider when buying bond ETFs?

When purchasing bond ETFs, several factors play a key role in making the right choice for your investment strategy. One crucial aspect is the type of bonds included in the ETF. Government bonds typically offer greater security, while corporate bonds often promise higher returns, allowing you to invest your money in fixed-income securities in a targeted and efficient way. Additionally, you should pay attention to the maturity structure—short-term bonds are less sensitive to interest rate changes than long-term bonds.

Another important factor is the ETF's cost structure. A lower TER (total expense ratio) ensures fewer fees are deducted from your returns. The yield and risk of the ETF are also heavily influenced by the credit quality of the bonds it contains: bonds with high credit ratings are more stable but generally offer lower interest rates.

Furthermore, check whether the ETF is distributing or accumulating, depending on whether you prefer regular interest payments or want the returns from these investments to be reinvested automatically.

What types of bond ETFs are available?

Bond ETFs can be categorised based on the type of bonds they track and how the returns are managed.

Government bond ETFs

These ETFs invest in bonds issued by countries such as Germany or other nations. They are considered particularly safe but typically offer lower returns.

Corporate bond ETFs

These focus on bonds issued by companies. They tend to provide higher yields but come with increased risk.

High-yield bond ETFs

These ETFs invest in bonds with lower credit ratings but offer more attractive interest rates in return.

Bond ETFs also differ based on the remaining maturity of the bonds they include:

• Short-term bond ETFs contain bonds with shorter maturities and are less affected by interest rate fluctuations

• Long-term bond ETFs include bonds with longer maturities and benefit more from falling interest rates

Regarding income distribution, there are two main types:

• Distributing bond ETFs regularly pay out interest income, appealing to investors seeking ongoing earnings

• Accumulating bond ETFs reinvest the interest automatically, ideal for long-term investors aiming to benefit from compound interest rates

Depending on your risk tolerance and investment horizon, you can choose between these different ETF types to achieve your individual goals.

Where can I buy a bond ETF?

In Germany, you can purchase bond ETFs through various channels. These include online brokers that facilitate trading on exchanges such as Xetra or the Frankfurt Stock Exchange. Here, you open a securities account and can search for suitable bond ETFs to trade at current market prices.

Many direct banks also offer bond ETFs and often provide ETF savings plans. Alternatively, you can buy bond ETFs directly via well-known exchanges tailored to the German market.

Compare costs and available trading options before buying to find the right provider for your investment strategy.

Advantages and disadvantages of bond ETFs

Bond ETFs offer numerous advantages but also come with certain risks. Here’s an overview:

Advantages:

• Diversification through broad exposure

• Flexible trading on the stock exchange

• Lower costs compared to actively managed funds

• Stable returns via regular interest payments

Disadvantages:

• Interest rate risk in a rising interest rate environment

• No guaranteed repayment as with individual bonds

• Credit risk for lower-quality bonds

Conclusion: are bond ETFs worth it?

Bond ETFs are particularly worthwhile for investors seeking stable returns, broad risk diversification and ease of use. They provide a cost-effective way to invest in bonds without directly purchasing individual ones. The suitability of a bond ETF depends on your goals, risk tolerance and investment horizon.

However, bond ETFs also carry disadvantages, such as interest rate risk and potential price losses in a rising rate environment. These can be mitigated by carefully selecting ETFs with varying maturities or focusing on short-term bonds.

In summary, bond ETFs are a valuable addition to align stability and returns. They can help cushion portfolio fluctuations during volatile market phases and secure regular income. For long-term investments, bond ETFs offer a low-cost, low-risk way to diversify your capital.

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