Guide to fixed income investing with ETFs

Fixed income can be an important part of an investor’s portfolio, especially for those who have a short time horizon or prioritize capital preservation. While many investors have previously relied on selecting and investing in individual bonds to help build out their fixed income allocation, fixed income ETFs can provide a simple and more efficient way to gain exposure to bonds within a portfolio. This guide to fixed income investing with ETFs will cover the different types of fixed income asset classes and the way their risk exposure differs, as well as the advantages that bond ETFs offer investors over purchasing individual bonds directly.

What are fixed income ETFs?

The term “fixed income” typically refers to the bond market due to bond securities’ provision of a fixed stream of income until maturity. Thus, fixed income ETFs are funds that invest in a collection of one or more different types of bonds. 

These ETFs can be passive, tracking an index of bonds, or they can be actively managed, meaning the portfolio manager has discretion over which bonds are held within the portfolio as long as it falls within the ETF’s investment mandate. Unlike investing in individual bonds, bond ETFs do not mature. Holdings are bought and sold, typically maintaining the duration of the bond ETF within a specified range.

What are the different types of fixed income asset classes?

There are many different types of fixed income, each with their own unique set of risks. 

Government bonds

Some of the lowest-risk bonds are government bonds, such as Treasuries. Government bonds are debt securities that are issued by a government in order to support spending. Treasury bonds have a relatively low risk of default, as they are backed by the U.S. government, but do have exposure to interest rate risk.

Corporate bonds

Corporate bonds are debt securities that are issued by corporations. These bonds are issued to fund company operations and are backed by the ability of the company to pay. This means that investors in corporate bonds have exposure to both credit rate and interest risk. As companies can differ widely in their prospects for future revenues and profitability, these bonds can be further divided into investment grade or high yield depending upon their credit rating. High yield bonds, otherwise known as junk bonds, offer a higher rate of interest due to having a greater chance of default. 

Municipal bonds

Municipal bonds are debt securities that are issued by public entities such as states, municipalities, or counties. These types of bonds typically have preferential tax treatment and low risk of default, making them attractive investments for many high-net-worth investors.

Why should you invest in fixed income ETFs?

Relative to stocks, bonds typically have lower levels of volatility and are used within a portfolio to provide capital preservation and a steady source of income. However, buying individual bonds within a portfolio can be time-consuming and difficult. Bond ETFs have several advantages over buying individual bonds.

Bond ETFs can offer diversified exposure to the fixed income market, with hundreds or even thousands of bonds held within an ETF. And as mentioned, bond ETFs never mature as the bond holdings within are being bought and sold to maintain the desired exposure. This makes them an easy and efficient way for investors to allocate to fixed income.

Fixed income ETFs can also provide simple exposure to areas of the market that might be more difficult to get access to, such as local currency emerging market debt. Bond ETFs can also provide a high level of liquidity and pricing transparency for parts of the market that are relatively illiquid and opaque.

What are the risks of fixed income ETFs?

Fixed income ETFs are typically exposed to two distinct types of risk: credit risk and interest rate risk. Fixed income ETFs can hold one or more of the different types of bonds, as explained above, from domestic or international governments and corporations. Investors should be sure to understand the ability of the issuer to repay the bond obligation by evaluating the average credit quality of the bond ETF.

In addition, bond ETFs can have differing maturities ranging from ultrashort-term (< 1 year) to long-term (20 years+), affecting the duration of the bond ETF. Duration is a measure of sensitivity to interest rates. The higher the duration, the greater the negative effect on a bond ETF’s price when interest rates rise.

Investors in fixed income ETFs should understand both the interest rate risk and credit risk of their investment before making an allocation.