How Do Bond ETFs Pay Interest?

Individual bonds, on the other hand, are sold over the counter by bond brokers and trade on a controlled exchange throughout the day. Traditional bond structures make it difficult for investors to find a bond with a reasonable pricing. Bond exchange-traded funds (ETFs) sidestep this problem by trading on large indices like the New York Stock Exchange (NYSE).

As a result, they can give investors access to the bond market while maintaining the convenience and transparency of stock trading. Individual bonds and mutual funds, which trade at one price each day after the market closes, are less liquid than bond ETFs. Investors can also trade a bond portfolio during difficult circumstances, even if the underlying bond market is not performing well.

Bond ETFs pay out interest in the form of a monthly dividend and capital gains in the form of an annual payout. These dividends are classified as either income or capital gains for tax purposes. Bond ETFs’ tax efficiency, on the other hand, isn’t a large concern because capital gains aren’t as important in bond returns as they are in stock returns. Bond ETFs are also available on a worldwide scale.

Does a bond ETF pay dividends or interest?

The seemingly straightforward bond ETF may be the most misunderstood investment in recent years.

Bond-related exchange-traded funds account for a little more than a quarter of the $42 billion invested in ETFs in Canada, and four of the top ten ETFs are bond-related. Bond ETFs have clearly proven to be a more efficient and cost-effective alternative to bond mutual funds and buying bonds individually.

But, if the questions I get from readers are any indicator, some people who buy bond ETFs aren’t quite aware of how they function. To be clear, this edition of the Portfolio Strategy is intended to serve as a bond ETF owner’s guide.

An exchange-traded fund (ETF) is a vehicle for investing in any of a number of indexes that track bonds of various kinds, including those issued by governments and both blue-chip and less financially solid firms. Investors should get the return of the bond ETF’s underlying index, minus the management expense ratio and any fees levied by an investment adviser (not applicable to do-it-yourself investors).

Because bond ETFs move like stocks, brokerage trading commissions must be factored in. It’s worth noting that certain brokers now offer commission-free ETF trading (see for more information).

Some bond ETFs are designed to provide comprehensive, diversified coverage of the entire bond market, including government and corporate bonds. Other products are aimed at allowing investors to customize their bond portfolios. They may, for example, mix low-yielding but safe short-term government and corporate bonds with real-return bonds to safeguard against inflation and high-yield bonds to boost returns (and risk).

Bond ETFs, like bonds, will appreciate in value as interest rates decrease and decline as rates rise. Bond ETFs, on the other hand, track their respective bond indexes without ever maturing, whereas bonds will ultimately mature and give you back your investment.

Many bond ETFs pay interest on a monthly basis, despite the fact that individual bonds normally pay only twice a year. Some ETFs pay out the same amount of money every month, while others change the amount of money they pay out.

Interest income is the primary source of income, but if you purchase a growing ETF, you may also enjoy capital gains and a tiny return of capital. This is due to the accounting regulations for ETFs that receive a large amount of fresh money.

At the low end, a bond ETF holding short-term bonds can be purchased for as little as 0.17 percent. It’s not clear why, but MERs for ETFs that contain longer-term bonds, corporate bonds, and high-yield bonds are higher. The top end of the market has MERs of roughly 0.65%, compared to an average of 1.25% for the 10 largest bond mutual funds.

Small investors are already at a disadvantage in the bond market: Individual investors pay a lot more for bonds than institutional investors, such as those who manage bond ETFs. The higher the yield, the lower the price paid for the bond.

Do not make the error of looking for a bond ETF stock quote and estimating your actual return based on the yield displayed. This yield is calculated using interest payments over the preceding 12 months and the bond ETF’s current share price. This so-called distribution yield, similar to the coupon on a bond, can be used to estimate how much income you can expect from the ETF. A bond’s interest payments are represented by the coupon.

The yield to maturity, which can be found on the product profiles that all businesses selling exchange-traded funds provide on their websites, is the right measure of a bond ETF’s return. Because of the different assumptions that go into the computation, yield to maturity is an estimated number. Still, as one ETF industry insider puts it, “that’s the best you can do” when it comes to calculating your yield. To achieve a net return, subtract the management charge from the indicated yield to maturity.

Despite this, some investors continue to prioritize distribution yield over yield to maturity, which is understandable. Today, the distribution yield is almost always significantly higher. Take the iShares DEX Universe Bond Index Fund (XBB), Canada’s largest bond fund: The distribution yield is 3.6 percent, with a 2.3 percent yield to maturity.

What’s the deal with the discrepancy? Because many of the bonds in the XBB portfolio were issued when interest rates were higher than they are now. As a result, the issue price of these bonds has climbed above its issue price, but it will gradually return to that level as the maturity date approaches. This drop in price is accounted for in yield to maturity, which is a total return that incorporates both interest and predicted price movements in bond ETF shares.

It’s worth noting that the yield to maturity isn’t always lower than the distribution yield. We could witness a reversal of this pattern if interest rates rise rapidly.

  • Averaging the interest payments produced by bonds in a portfolio based on their weighting. Price changes for the bonds are not taken into account.
  • Weighted average duration: A measure of interest-rate sensitivity. If rates rise by a single percentage point, however many years of duration a bond portfolio has on average, that is how many percentage points it will decline in price (the opposite applies, too). XBB has a 6.7-year duration, which means that a one-point increase would result in a 6.7-point drop. The durations of the iShares family’s short and long-term bond ETFs are 2.6 and 13.7 years, respectively.
  • The average time period over which the bonds in the ETF will mature is known as the weighted average term.
  • Ratings: Indicates how bond rating organizations rated the bonds in your portfolio. Triple-B and higher are regarded as excellent. Less than that will yield better returns, but at the cost of increased risk.

The following is a list of exchange-traded funds (ETFs) that track Canadian market bond indexes that are listed on the Toronto Stock Exchange (TSX).

What makes bond ETFs profitable?

The closer a bond’s maturity date approaches, the more vulnerable it is to rate increases. When all other factors are equal, a 10-year bond has a higher interest rate risk than a five-year bond since your money is exposed to rising interest rates for a longer length of time.

A time-weighted measure of interest-rate risk is called duration. Duration predicts how a bond’s price will fluctuate in reaction to interest rate fluctuations. More interest-rate risk is associated with longer periods. A duration of 3.5, for example, suggests that if interest rates rise by 1%, the value of a bond will fall by 3.5 percent.

  • The duration is a guess, not a guarantee. Bond prices rise when interest rates fall, but this isn’t a one-to-one relationship. Price increases from dropping rates are undervalued by duration, whereas price declines from rising yields are overestimated.
  • Duration is based on a simplified interest-rate scenario. When interest rates move by 1% across all maturities, duration is calculated; in other words, when rates change, the entire yield curve shifts by 1% up or down. It’s rare that reality is so exact.

Bond ETFs typically pay out income on a monthly basis. One of the most appealing features of bonds is that they pay interest to investors on a regular basis, usually every six months. Bond ETFs, on the other hand, hold a variety of issues at once, and some of the bonds in the portfolio may be paying their coupons at any one time. As a result, bond ETFs often make monthly rather than semiannual coupon payments. This payment’s amount varies from month to month.

Traditional bond indexes are excellent benchmarks but poor portfolio builders. The majority of equities ETFs hold all of the securities in their index. However, with bonds, this is usually not possible. Hundreds, if not thousands, of individual securities are frequently included in bond indexes. It’s not only tough, but also expensive to buy all those bonds for an ETF’s portfolio. Even if the purchase of thousands of bonds in illiquid markets has a minor impact on the index, the cost of doing so can significantly erode returns.

Managers of bond ETFs frequently tweak their indexes. To keep expenses down, fund managers must often pick and select which bonds from the bond index to include in the ETF. They’ll choose bonds that, based on credit quality, exposure, correlations, duration, and risk, provide the best representative sample of the index. The term “optimization” or “sampling” refers to this process.

Optimizing saves money, but it comes with its own set of hazards. Over time, an ETF’s returns may diverge from those of its index, depending on how aggressively its portfolio was optimized. The majority of ETFs closely track their underlying indexes; nevertheless, a few have fallen short of their benchmark by a few percentage points or more per year. (For further information, see “How To Run An Index Fund: Full Replication vs. Optimization.”)

Individual bond values are difficult to estimate. There is no one agreed-upon price for the value of every bond without an official exchange. Many bonds, in reality, do not trade on a daily basis; particular forms of municipal bonds, for example, can go weeks or months without trading.

To calculate NAV, fund managers need precise bond prices. Bond pricing services, which estimate the value of individual bonds based on recorded trades, trading desk surveys, matrix models, and other factors, are used by both mutual fund and ETF managers. Of course, nothing is certain. But it’s a reasonable guess.

The share price of an ETF isn’t the same as its NAV. The share price of a bond mutual fund is always the same as its net asset value, or the value of the underlying securities in the portfolio. The share price of a bond ETF, on the other hand, can fluctuate depending on market supply and demand. When share prices rise above NAV, premiums form, and when prices fall below NAV, discounts form. However, there is a natural mechanism in place to maintain the share price and NAV of a bond ETF in sync: arbitrage.

Arbitrage is used by APs to keep ETF share prices and NAV in sync. Authorized participants (APs), a special class of institutional investors, have the ability to create or destroy shares of the ETF at any time. If an ETF’s share price falls below its NAV, APs can profit from the difference by purchasing ETF shares on the open market and trading them into the issuer in exchange for a “in kind” exchange of the underlying bonds. The AP only needs to liquidate the bonds in order to profit. Similarly, if the share price of an ETF increases above NAV, APs can buy individual bonds and exchange them for ETF shares. Arbitrage produces natural purchasing or selling pressure, which helps keep the share price and NAV of an ETF from drifting too far apart.

An ETF’s price may be significantly below its declared NAV in stressed or illiquid markets, or for an extended length of time. When this happens, it simply signifies that the ETF industry believes the bond pricing service is incorrect, and that the prices for the fund’s underlying bonds are being overestimated. In other words, the APs don’t think they’ll be able to sell the underlying bonds for their stated valuations. This means that the ETF price falls below its NAV, which is good news for ETF investors. (Any premiums that may accrue follow the same procedure.)

Large premiums and discounts in a bond ETF don’t always indicate mispricing. Highly liquid bond ETFs can perform price discovery for the bonds they hold, and an ETF’s market price can actually be a better approximation of the aggregate value of the underlying bonds than its own NAV.

Bond funds pay interest in a variety of ways.

Bond funds, as the name implies, invest in debt issued by corporations or governments. While not all bonds pay annual interest, the great majority do.

A bond fund’s income is derived directly from the coupon payments generated by the bonds in its portfolio. Unless the fund invests in zero-coupon bonds, each asset in the portfolio pays a fixed amount of interest each year, known as the coupon rate, which is subsequently passed on to shareholders based on their fund investments.

Pros of bond ETFs

  • A bond ETF distributes the interest it earns on the bonds it owns. As a result, a bond ETF can be an excellent method to build up an income stream without having to worry about individual bonds maturing or being redeemed.
  • Dividends paid on a monthly basis. Some of the most popular bond ETFs pay monthly dividends, providing investors with consistent income over a short period of time. This means that investors can use the regular dividends from bond ETFs to create a monthly budget.
  • Immediate diversification is required. A bond ETF can provide rapid diversification throughout your entire portfolio as well as inside the bond segment. As a result, if you add a bond ETF to your portfolio, your returns will be more resilient and consistent than if you simply had equities in your portfolio. Diversification reduces risk in most cases.
  • Bond exposure that is tailored to your needs. You can have multiple types of bond ETFs in your bond portfolio, such as a short-term bond fund, an intermediate-term bond fund, and a long-term bond fund. When added to a stock-heavy portfolio, each will react differently to fluctuations in interest rates, resulting in a less volatile portfolio. This is advantageous to investors because they may pick and choose which market segments they want to acquire. Do you only want a small portion of intermediate-term investment-grade bonds or a large portion of high-yield bonds? Check and double-check.
  • There’s no need to look at individual bonds. Rather than researching a range of individual bonds, investors can choose the types of bonds they want in their portfolio and then “plug and play” with the appropriate ETF. Bond ETFs are also a great option for financial advisers, particularly robo-advisors, who are looking to round out a client’s diverse portfolio with the correct mix of risk and return.
  • It’s less expensive than buying bonds directly. Bond markets are generally less liquid than stock markets, with substantially greater bid-ask spreads that cost investors money. By purchasing a bond ETF, you are leveraging the fund company’s capacity to obtain better bond pricing, lowering your own expenses.
  • You don’t require as much cash. If you want to buy a bond ETF, you’ll have to pay the price of a share (or even less if you choose a broker that permits fractional shares). And that’s a lot better than the customary $1,000 minimum for buying a single bond.
  • Bond ETFs also make bond investment more accessible to individual investors, which is a fantastic feature. In comparison to the stock market, the bond market can be opaque and lack liquidity. Bond ETFs, on the other hand, are traded on the stock exchange like stocks and allow investors to quickly enter and exit positions. Although it may not appear so, liquidity may be the single most important benefit of a bond ETF for individual investors.
  • Tax-efficiency. The ETF structure is tax-efficient, with minimal, if any, capital gains passed on to investors.

Cons of bond ETFs

  • Expense ratios could be quite high. If there’s one flaw with bond ETFs, it’s their expense ratios — the fees that investors pay to the fund management to administer the fund. Because interest rates are so low, a bond fund’s expenses may eat up a significant percentage of the money provided by its holdings, turning a small yield into a negligible one.
  • Returns are low. Another potential disadvantage of bond ETFs has less to do with the ETFs themselves and more to do with interest rates. Rates are expected to remain low for some time, particularly for shorter-term bonds, and the situation will be aggravated by bond expense ratios. If you buy a bond ETF, the bonds are normally chosen by passively mirroring an index, thus the yields will most likely represent the larger market. An actively managed mutual fund, on the other hand, may provide some extra juice, but you’ll almost certainly have to pay a higher cost ratio to get into it. However, in terms of increased returns, the extra cost may be justified.
  • There are no promises about the principal. There are no assurances on your principal while investing in the stock market. If interest rates rise against you, the wrong bond fund might lose a lot of money. Long-term funds, for example, will be harmed more than short-term funds as interest rates rise. If you have to sell a bond ETF while it is down, no one will compensate you for the loss. As a result, for some savers, a CD may be a preferable option because the FDIC guarantees the principal up to a limit of $250,000 per person, per account type, at each bank.

Is it possible to lose money on a bond ETF?

  • Market transparency is lacking. Bonds are traded over-the-counter (OTC), which means they are not traded on a single exchange and have no official agreed-upon price. The market is complicated, and investors may find that different brokers offer vastly different prices for the same bond.
  • High profit margins. Broker markups on bond prices can be significant, especially for smaller investors; according to one US government research, municipal bond markups can reach 2.5 percent. The cost of investing in individual bonds can quickly pile up due to markups, bid/ask gaps, and the price of the bonds themselves.
  • Liquidity issues. Liquidity of bonds varies greatly. Some bonds are traded daily, while others are traded weekly or even monthly, and this is when markets are at their best. During times of market turmoil, some bonds may cease to trade entirely.

A bond ETF is a bond investment in the form of a stock. A bond ETF attempts to replicate the performance of a bond index. Despite the fact that these securities only contain bonds, they trade on an exchange like stocks, giving them some appealing equity-like characteristics.

Bonds and bond ETFs may have the same underlying investments, however bond ETFs’ behavior is affected by exchange trading in numerous ways:

  • Bond ETFs do not have a maturity date. Individual bonds have a definite, unchanging maturity date when investors receive their money back; each day invested brings that day closer. Bond ETFs, on the other hand, maintain a constant maturity, which is the weighted average of all the bonds in the portfolio’s maturities. Some of these bonds may be expiring or leaving the age range that a bond ETF is targeting at any given time (e.g., a one- to three-year Treasury bond ETF kicks out all bonds with less than 12 months to maturity). As a result, fresh bonds are regularly purchased and sold in order to maintain the portfolio’s maturity.
  • Even in illiquid markets, bond ETFs are liquid. Single bonds have a wide range of tradability. Some issues are traded on a daily basis, while others are only traded once a month. They may not trade at all during times of stress. Bond ETFs, on the other hand, trade on an exchange, which means they can be purchased and sold at any time during market hours, even if the underlying bonds aren’t trading.

This has real-world ramifications. According to one source, high-yield corporate bonds trade on less than half of the days each month, but the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) trades millions of shares per day.

  • Bond ETFs pay a monthly dividend. One of the most appealing features of bonds is that they pay out interest to investors on a regular basis. These coupon payments are usually made every six months. Bond ETFs, on the other hand, hold a variety of issues at once, and some of the bonds in the portfolio may be paying their coupons at any one time. As a result, bond ETFs often pay interest monthly rather than semiannually, and the amount paid can fluctuate from month to month.
  • Diversification. You can own hundreds, even thousands, of bonds in an index with an ETF for a fraction of the cost of buying each issue individually. At retail prices, it’s institutional-style diversification.
  • Trading convenience. There’s no need to sift through the murky OTC markets to argue over rates. With the click of a button, you may purchase and sell bond ETFs from your regular brokerage account.
  • Bond ETFs can be bought and sold at any time during the trading day, even in foreign or smaller markets where individual securities may trade infrequently.
  • Transparency in pricing. There’s no need to guess how much your bond ETF is worth because ETF values are published openly on the market and updated every 15 seconds during the trading day.
  • More consistent revenue. Instead of six-monthly coupon payments, bond ETFs often pay interest monthly. Monthly payments provide bond ETF holders with a more consistent income stream to spend or reinvest, even if the value varies from month to month.
  • There’s no assurance that you’ll get your money back. Bond ETFs never mature, so they can’t provide the same level of security for your initial investment as actual bonds may. To put it another way, there’s no guarantee that you’ll get your money back at some point in the future.

Some ETF providers, however, have recently began creating ETFs with defined maturity dates, which hold each bond until it expires and then disperse the proceeds once all bonds have matured. Under its BulletShares brand, Guggenheim offers 16 investment-grade and high-yield corporate bond target-maturity-date ETFs with maturities ranging from 2017 to 2018; iShares offers six target-maturity-date municipal ETFs. (See “I Love BulletShares ETFs” for more information.)

  • If interest rates rise, you may lose money. Rates of interest fluctuate throughout time. Bonds’ value may fall as a result of this, and selling them could result in a loss on your initial investment. Individual bonds allow you to reduce risk by simply holding on to them until they mature, at which point you will be paid their full face value. However, because bond ETFs don’t mature, there’s little you can do to avoid the pain of rising rates.

Individual bonds are out of reach for the majority of investors. Even if it weren’t, bond ETFs provide a level of diversification, liquidity, and price transparency that single bonds can’t match, plus intraday tradability and more regular income payouts. Bond ETFs may come with some added risks, but for the ordinary investor, they’re arguably a better and more accessible option.

Is it true that bond ETFs are more tax-efficient?

ETFs, on the other hand, are more tax-efficient than mutual funds due to their structure. In this way, mutual funds simply cannot compete with ETFs. However, while ETFs have a tax advantage over stock funds, bond funds do not often have large capital gains.

Are bond exchange-traded funds (ETFs) tax-efficient?

The Sit Rising Rate ETF is an exception (RISE). This ETF is officially a commodities pool because it uses futures contracts and options on Treasurys. That is to say:

  • The profits of RISE are taxed differently. The long-term capital gains rate of 20% will be applied to 60% of any gains. No of how long you held your shares, the remaining 40% is taxed at your usual income rate. This equals a 27.84 percent blended maximum capital gains rate.
  • RISE is a “pass-through” investment, which means that profits must be “marked to market” at the end of the year and distributed to shareholders. (“Marked to market” means that the ETF’s futures contracts will be treated as if it had sold them for tax reasons.) Whether or not you sold your shares, you may be liable for taxes on those profits.
  • A Schedule K-1 form is generated by RISE. For taxpayers who are unfamiliar with K-1s, they can be perplexing and time-consuming.
  • RISE may also generate Unrelated Business Taxable Income (UBTI), which could be taxable in nontaxable accounts like an IRA, though this is rare.

The Internal Revenue Service (IRS) doesn’t only tax the earnings you received from selling your bond ETF shares. It also taxes any bond ETF payouts you may have received.

Interest payments from bond ETFs are taxed as ordinary income. Bond ETFs provide owners regular (typically monthly) coupon payments, which is one of their main selling features. This money, however, is taxable. Despite being referred to as “dividends,” the IRS does not consider these payments to be qualified dividends, and hence do not qualify for the reduced qualified dividends tax rate. Instead, they’re taxed as ordinary income, with a top rate of 39.6% if they’re taxable at all… assuming they’re taxable at all (more on that below).

Bond ETFs are more likely to deliver capital gains than stock ETFs. Bond ETF managers are frequently required to buy and sell securities throughout the year in order to maintain a specific duration or maturity range. Bonds mature on a regular basis, and bond ETF managers can’t use the same tax-loss harvesting tactics that they do with equities. (For further information, see “Why Are ETFs So Tax Efficient?”) This could eventually lead to an annual capital gains distribution. While the great majority of ETFs do not pay out capital gains to investors each year, the ones that do are typically bond ETFs.

The capital gains dividends from bond ETFs are often quite minimal. These dividends are often less than 1% of the ETF’s net asset value. The capital gains distribution for the iShares Core U.S. Aggregate Bond ETF (AGG | A-98) was only 0.08 percent of NAV in 2014. Gains of 0.26 percent were given by the Vanguard Total Bond Market ETF (BND | A-94). Bond ETFs with constrained maturities, on the other hand, will have larger statistics.

Are bond ETFs better than mutual funds in terms of tax efficiency?

When compared to typical mutual funds, ETFs can be more tax efficient. In general, keeping an ETF in a taxable account will result in lower tax liabilities than holding a similarly structured mutual fund.

ETFs and mutual funds have the same tax status as mutual funds, according to the IRS. Both are subject to capital gains and dividend income taxes. ETFs, on the other hand, are constructed in such a way that taxes are minimized for ETF holders, and the final tax bill (after the ETF is sold and capital gains tax is paid) is less than what an investor would have paid with a similarly structured mutual fund.

In 2021, how will bonds perform?

Corporate bonds performed well in the first half of 2021, with high yield bonds leading the way. The price decreases linked to rising Treasury rates were cushioned by demand for yield and a stronger credit quality outlook. Despite this, investment-grade corporate bonds had negative total returns in the first half of the year, while lower-credit-quality high-yield bonds had positive total returns.