Fixed income investing: The ETF approach

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Fixed-income ETFs are bond funds whose shares are listed on a stock exchange and traded throughout the day. There are fixed-income ETFs that focus on corporate, government, municipal, international, and global debt, as well as funds that track the broader Bloomberg Barclays Aggregate Bond Index.Footnote 1 In addition, investors may purchase bond ETFs that focus on specific ranges of maturity dates.
Like mutual funds, fixed-income ETFs may provide a convenient way to diversify a bond investment conveniently among a number of different bond issues with a single transaction. ETFs may also pay regular interest and they typically do not have a specific maturity date.

Fixed-income ETFs vs. mutual funds: Important distinctions

Here is a summary of some key differences between bond ETFs and bond mutual funds.
Mutual fund share prices are recalculated daily to take account of changes in the appraised market value of the fund's holdings, i.e., its net asset value (NAV). The mutual fund company is required to buy or sell shares at NAV. A bond ETF's shares, by contrast, are priced in response to the market demand for the ETF's shares. An ETF's daily trading price may vary from that ETF's official NAV.
ETF shares are traded through a stock brokerage at the broker's applicable commission rate. Mutual fund shares may be purchased from a stock broker or other financial professional, or they may be purchased directly from the fund company. These shares may be sold with an initial sales load, an ongoing management or marketing fee, a redemption charge, or some combination of those.
Many bond mutual funds are actively managed and may have significant amounts of turnover in their portfolios. Bond ETF portfolios, by contrast, generally tend to mirror the composition of fixed-income market benchmarks and have correspondingly lower turnover.
Investors with shares in bond ETFs may have more ready access to information about fund holdings. The underlying securities of fixed-income ETFs usually are reported daily online. Bond mutual funds, by contrast, are required to reveal their holdings semiannually, although many do so more frequently — often monthly — on their Web sites.

Fixed-income ETFs and mutual funds: A look inside

Although there are similarities, the table below spells out some of the different characteristics of bond ETFs and fixed-income mutual funds.
Fixed-income ETF Fixed-income mutual fund
Pricing Changes throughout the trading day, depending on investor demand. Established once a day after the market closes.
Net asset value May be higher or lower than the price at which the fund trades. Identical to the share price.
Shareholder reporting Holdings are disclosed daily online. Rules require holdings to be reported semiannually, although many firms disclose them more often.
Liquidity May be traded throughout the day. Rules require holdings to be reported semiannually, although many firms disclose them more often.
Expenses Investors pay brokerage commissions when buying or selling shares. Annual expense ratio typically is less than that of a mutual fund.Footnote 2 Many mutual fund companies impose redemption fees, 12b-1 fees or sales loads. These are detailed in the prospectus for the mutual fund share class.

Bond ETFs vs. bond ladders

Creating a laddered bond portfolio — in which an investor purchases a series of bonds that mature at various intervals and replaces them with newer, potentially higher-yielding securities — is a popular fixed-income strategy, and it may be worth exploring how bond ETFs compare with this practice. Bond ladders provide an opportunity to customize a portfolio, whereas fixed-income ETFs may not offer this option. ETFs, however, provide convenience, because an investor is not required to continuously purchase new securities.
Also, it's important to note that investors can access intraday and historical pricing of shares in bond ETFs. In contrast, pricing information of individual bonds may be more restricted. The bond market traditionally has operated as an over-the-counter trading system dominated by institutional investors. Pricing of individual bonds, along with the commissions that investors have paid to trade them, have been less transparent than in the equity market.
Whether used as the core of a fixed-income portfolio or in combination with mutual funds and individual securities, bond ETFs can offer many benefits for fixed-income investors.

Footnote 1 The Barclays U.S. Aggregate Bond Index measures the performance of the broad U.S. bond market and is composed of fixed-income securities rated investment grade (BBB- or higher or its equivalent), including U.S. government, corporate, and sovereign debt, and mortgage-backed and asset-backed securities. Investors cannot invest directly in any index. Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Holdings in municipal bond funds may be subject to the federal alternative minimum tax. Capital gains on the sale of fixed-income securities are taxable for federal and in many cases, state purposes.

Footnote 2 Source: NYSE Alternext US (formerly American Stock Exchange).

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Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.