Exchange Traded Funds, or ETFs for short, are mutual funds which trade on a stock exchange like the NYSE. In other words, ETFs trade just like stocks. When buying an ETF, you are not buying a piece of a company. Instead, you are buying a piece of an investment portfolio. Like Bond Mutual Funds, Bond ETFs provide investors with diversification by pooling the collective buying power of investors in the ETF, which in turn holds a large portfolio of bonds.
Most Bond ETFs are designed to track an underlying index, which can be broad (ie the entire US Bond Market) or narrow (ie junk corporate bonds). One widely used broad index is The Barclays Capital Aggregate Bond Index, which tracks the performance of the overall US investment grade bond market, including treasury bonds, agency bonds, corporate bonds, and municipal bonds. Bond ETFs like the AGG and BND track this index which means that that the buying and selling decisions of the ETF manager are made based on changes in the underlying index, and not on their own market view. For a list of the top 5 Bond ETFs and the Indexes they track go here.
There is a major difference between how ETFs work and how mutual funds work. When you buy shares in a mutual fund, you are purchasing them directly from the mutual fund company. When you go to sell those shares, the transaction also happens with the mutual fund company. This has several implications for bond mutual fund investors:
When you buy and sell shares of a Bond ETF on the other hand, you are not transacting with the company that runs the ETF. Instead transactions happen between investors (buyers and sellers) over the exchange. This is an important distinction, which also means that:
The fees for investing in a bond ETF can be more or less than bond mutual fund fees, depending on how often and how much you are investing. To decide which option is going to be the most affective for your situation make sure you understand all the fees listed in our Bond ETF fees article. Then read our article “Are Bond ETFs Really Cheaper?”
There are literally hundreds of different kinds of bond ETFs, which generally fall into one of the below 3 categories:
Within each of the above categories there are multiple ETFs which focus on investing in different maturities and segments of each category. To help you decide on which category or categories of bond funds are right for you see our article on what you can expect from different types of bond funds.
This lesson is part of our Free Guide to the Basics of Investing in Bond Funds. Continue to the next lesson here.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.