What Are Fixed Income ETFs? Key Things to Know

Fixed income exchange-traded funds (ETFs) are investment vehicles offering exposure to the bond market. These funds trade on stock exchanges throughout the day, much like individual stocks. They hold a diversified collection of bonds, providing investors with a single security that aims to generate regular income and add diversification to portfolios.

Understanding Fixed Income ETFs

Fixed income refers to investments providing a predictable stream of payments over a defined period, typically returning the initial principal at maturity. Bonds are a primary example of fixed income securities, where an issuer borrows money and agrees to pay interest at regular intervals until the loan is repaid. An ETF is an investment fund holding assets like stocks, bonds, or commodities that trades on stock exchanges.

Fixed income ETFs pool money from many investors to buy a portfolio of various bonds. This structure offers advantages over buying individual bonds, such as instant diversification across numerous issuers and maturities, which helps spread risk. They also require a lower minimum investment compared to constructing a diversified bond portfolio directly.

Compared to traditional bond mutual funds, fixed income ETFs offer the flexibility of intra-day trading, allowing investors to buy and sell shares throughout the trading day at market prices. This contrasts with mutual funds, which are priced only once at the end of each trading day based on their net asset value. ETFs also provide greater transparency, with holdings often disclosed daily.

Categories of Fixed Income ETFs

Fixed income ETFs are categorized by the types of bonds they include, reflecting different risk and return profiles.

Government Bond ETFs

These invest in debt issued by national governments or their agencies, such as U.S. Treasuries. They have low credit risk because they are backed by the issuing government.

Corporate Bond ETFs

These hold debt issued by companies, from large corporations to smaller firms. They divide into investment-grade bonds, which carry higher credit ratings and lower default risk, and high-yield or “junk” bonds, which offer higher potential returns but come with increased credit risk.

Municipal Bond ETFs

These invest in debt issued by state and local governments to fund public projects. Interest income is often exempt from federal income tax. For residents of the issuing state, income may also be exempt from state and local taxes, making them attractive for investors in higher tax brackets.

International Bond ETFs

These provide exposure to debt issued by foreign governments or corporations. These funds introduce currency risk and can be influenced by economic conditions and interest rate policies in other countries.

Specialty Bond ETFs

These focus on specific types of fixed income securities. Inflation-protected securities (TIPS) ETFs, for example, invest in U.S. Treasury bonds whose principal value adjusts with the Consumer Price Index (CPI), offering protection against inflation. Mortgage-backed securities (MBS) ETFs hold bonds backed by pools of mortgage loans. Payments to investors in MBS ETFs come from the principal and interest payments made by homeowners.

How Fixed Income ETFs Operate

Fixed income ETFs function similarly to stocks; their shares are bought and sold on major stock exchanges throughout the trading day. The price at which an ETF trades can fluctuate based on market supply and demand, which may differ slightly from its Net Asset Value (NAV). The NAV represents the per-share value of the ETF’s underlying bond holdings, calculated at the end of each trading day.

A mechanism involving “Authorized Participants” (APs) helps keep the ETF’s market price closely aligned with its NAV. APs can create new ETF shares by depositing a basket of the underlying bonds with the fund, or redeem shares for bonds, a process known as creation and redemption. This process ensures liquidity and helps prevent large premiums or discounts from developing between the market price and the NAV.

Income for fixed income ETF shareholders comes from interest payments received from bonds held within the fund’s portfolio. The fund manager collects these payments and distributes them to shareholders regularly. Most fixed income ETFs make these distributions monthly or quarterly, providing a consistent income stream. The fund handles managing the bond portfolio, including reinvesting maturing bonds and adjusting holdings based on market conditions.

Key Factors for Evaluating Fixed Income ETFs

When evaluating fixed income ETFs, several objective factors help investors assess suitability.

Credit Quality

This refers to the financial soundness of bond issuers within the ETF’s portfolio, indicating their ability to repay debt. Ratings from agencies like Standard & Poor’s or Moody’s, ranging from investment-grade (e.g., BBB- or higher) to high-yield (below BBB-), reflect this. An ETF primarily holding investment-grade bonds carries lower default risk but may offer lower yields compared to an ETF with significant exposure to high-yield bonds.

Interest Rate Sensitivity

Often measured by duration, this indicates how much an ETF’s price is expected to change in response to a shift in interest rates. A higher duration means the ETF’s price will be more volatile; for instance, an ETF with a duration of seven years might see its price drop by approximately 7% if interest rates rise by one percentage point.

Expense Ratio

This is the annual fee charged by the fund as a percentage of assets managed, directly reducing the investor’s overall return. A lower expense ratio, such as 0.15% or less for broad market funds, means more of the investment returns are retained by the investor.

Liquidity

This describes how easily and efficiently an ETF’s shares can be bought or sold in the market without significantly impacting their price. High trading volume and a narrow bid-ask spread, typically less than 0.10%, suggest good liquidity, allowing investors to execute trades quickly and at fair prices.

Yield

This represents the income an ETF generates relative to its price, often expressed as a current yield or distribution yield. This metric indicates the potential income an investor can expect from holding the fund.

Tax Implications

The tax treatment of income varies by bond type. Income from corporate bond ETFs is subject to federal, state, and local income taxes. Income from municipal bond ETFs may be exempt from federal income tax, and potentially from state and local taxes if the investor resides in the issuing state. Any capital gains realized from selling ETF shares are subject to capital gains taxes.