Bond Funds vs. Bond ETFs: What's the Difference?

Bond Funds vs. Bond ETFs: An Overview

Bond funds and bond ETFs or exchange-traded funds both invest in a basket of bonds or debt instruments. Bond funds or mutual funds contain a pool of capital from investors whereby the fund's manager allocates the capital to various securities. A bond ETF tracks an index of bonds with the goal of matching the returns from the underlying index.

Bond funds and bond ETFs share several characteristics, including diversification via portfolios that hold numerous bonds. Both funds and ETFs have smaller minimum required investments that would be necessary to achieve the same level of diversification by purchasing individual bonds in constructing a portfolio.

Before comparing bond funds and bond ETFs, it is worth taking a few moments to review the reasons why investors buy bonds. Most investors put bonds in a portfolio to generate income. A bond is a debt instrument that typically pays an interest rate, called a coupon rate each year to the bondholder. Although buying and selling bonds to generate a profit from fluctuations in their prices is a viable strategy, most investors invest in them for their interest payments.

Investors also buy bonds for risk-related reasons, as they seek to store their money in an investment that is less volatile than stocks. Volatility is the extent to which a security's price fluctuates over time.

Both bond funds and bond ETFs can pay dividends, which are cash payments from companies for investing in their securities. Both types of funds offer a wide variety of investment choices ranging from high-quality government bonds to low-quality corporate bonds and everything in between.

Both funds and ETFs can also be purchased and sold through a brokerage account in exchange for a small per-trade fee. Despite these similarities, bond funds and bond ETFs have unique, unshared characteristics.

Bond Funds

Mutual funds have been investing in bonds for many years. Some of the oldest balanced funds, which include allocations to both stock and bonds, date back to the late 1920s.

Accordingly, a large number of bond funds in existence offer a significant variety of investment options. These include both index funds, which seek to replicate various benchmarks and make no effort to outperform those benchmarks, and actively managed funds, which seek to beat their benchmarks.

Actively managed funds also employ credit analysts to conduct research into the credit quality of the bonds the fund purchases to minimize the risk of purchasing bonds that are likely to default. Default occurs when the issuer of the bond is unable to make interest payments or pay back the original amount invested due to financial difficulty. Each bond is assigned a credit quality grade by credit rating agencies that assess the financial viability of the issuer and the likelihood of default.

Bond funds are available in two different structures: open-ended funds and closed-end funds. Open-ended funds can be bought directly from fund providers, which means they do not need to be purchased through a brokerage account. If purchased directly, the brokerage commission fee can be avoided. Similarly, bond funds can be sold back to the fund company that issued the shares, making them highly liquid or easily bought and sold.

In addition, open-ended funds are priced and traded once a day, after the market closes and each fund’s net asset value (NAV) is determined. The trading price is a direct reflection of the NAV, which is based on the value of the bonds in the portfolio.

Open-ended funds do not trade at a premium or a discount, making it easy and predictable to determine precisely how much a fund’s shares will generate if sold. A bond sold at a premium has a higher market price than its original face value amount while a discount is when a bond is trading at a lower price than its face value.

Notably, some bond funds charge an extra fee if they are sold prior to a certain minimum required holding period (often 90 days), as the fund company wishes to minimize the expenses associated with frequent trading.

Bond funds do not reveal their underlying holdings on a daily basis. They generally release holdings on a semi-annual basis, with some funds reporting monthly. The lack of transparency makes it difficult for investors to determine the precise composition of their portfolios at any given time.

Bond ETFs

Bond ETFs are a far newer entrant to the market when compared to mutual funds, with iShares launching the first bond ETF in 2002. Most of these offerings seek to replicate various bond indices, although a growing number of actively managed products are also available.

ETFs often have lower fees than their mutual fund counterparts, potentially making them the more attractive choice to some investors all else being equal.

Bond ETFs operate much like closed-end funds, in that they are purchased through a brokerage account rather than directly from a fund company. Likewise, when an investor wishes to sell, ETFs must be traded on the open market, meaning that a buyer must be found because the fund company will not purchase the shares as they would for open-ended mutual funds.

Like stocks, ETFs trade throughout the day. The prices for shares can fluctuate moment by moment and may vary quite a bit over the course of trading. Extremes in price fluctuation have been seen during market anomalies, such as the so-called Flash Crash of 2010. Shares can also trade at a premium or a discount to the underlying net asset value of the holdings.

While significant deviations in value are relatively infrequent, they are not impossible. Deviations may be of particular concern during crisis periods, for example, if a large number of investors are seeking to sell bonds. In such events, an ETF's price may reflect a discount to NAV because the ETF provider is not certain that existing holdings could be sold at their current stated net asset value.

Bond ETFs do not have a minimum required holding period, meaning that there is no penalty imposed for selling rapidly after making a purchase. They can also be bought on margin and sold short, offering significantly greater flexibility in terms of trading than open-ended mutual funds. Margin involves borrowing money or securities from a broker to invest. Also, unlike mutual funds, bond ETFs reveal their underlying holdings on a daily basis, giving investors complete transparency.

Bond Fund or Bond ETF?

The decision over whether to purchase a bond fund or a bond ETF usually depends on the investment objective of the investor. If you want active management, bond mutual funds offer more choices. If you plan to buy and sell frequently, bond ETFs are a good choice. For long-term, buy-and-hold investors, bond mutual funds, and bond ETFs can meet your needs, but it's best to do your research as to the holdings in each fund.

If transparency is important, bond ETFs allow you to see the holdings within the fund at any given moment. However, if you're concerned about not being able to sell your ETF investment due to the lack of buyers in the market, a bond fund might be a better choice since you'll be able to sell your holdings back to the fund issuer.

As with most investment decisions, it's important to do your research and speak with your broker or financial advisor.