What is a Bond ETF?

Last Updated on October 16, 2023 by BFSLTeam BFSLTeam

Bonds are among the many financial instruments available for trading in the Indian markets. A bond is basically a debt instrument companies and governments issue to raise capital. In exchange, the fundraising entity pays interest to the investors for a predetermined tenure. At the end of the said tenure, the entity returns the borrowed funds to the investors.  As a bond investor, you get to enjoy certain benefits like a steady source of income by way of interest on your principal investment amount. Furthermore, by including bond investments in your portfolio, you can effectively lower the overall investment risk and prevent portfolio value erosion during adverse market movements.  Although you have the freedom to invest in individual bonds, market experts often consider bond ETFs as one of the best ways to invest in the debt instrument. Wondering what a bond ETF is and how it differs from a regular bond? Continue reading to find out all about this investment option.    

What is a Bond ETF? 

It is important to first address the concept of an ETF to be able to fully understand the meaning of a bond ETF. 

An exchange-traded fund (ETF) is a type of mutual fund that collects money from different investors and uses it to invest in a basket of similar or different assets. Unlike a regular mutual fund, however, an ETF is listed on a stock exchange like stocks. Interested investors can freely buy and sell units of exchange-traded funds among themselves.   

Now that you’re well-versed with the concept of an Exchange-Traded Fund, let’s get back to bond ETFs. 

A bond ETF is a category of mutual fund that invests the pooled money of investors in a basket of different bonds across multiple credit ratings and segments. One of the major advantages of a bond ETF is that it is a low-cost and low-risk investment option designed to provide exposure to the bond market, infuse some much-needed liquidity into your investment portfolio and provide a stable source of income.  

How Does a Bond ETF Differ from a Regular Bond and a Bond Mutual Fund? 

Now that you know the meaning of a bond ETF, let’s look at how it differs from a regular bond. 

A regular bond only provides exposure to one single bond. For instance, when you purchase a 91-day treasury bill, you only get exposure to that particular bond. A bond ETF, meanwhile, invests in a basket of different bonds. For instance, it may invest in an 182-day treasury bill, a few AAA-rated corporate bonds and two 10-year State Development Loans (SDLs). When you invest in such a bond ETF, you gain exposure to all of the bonds in its portfolio, effectively reducing risk through diversification. 

A bond mutual fund, on the other hand, is more similar to a bond ETF since it also invests in a basket of different bonds. However, unlike an ETF, a bond mutual fund is not listed on a stock exchange and traded freely between investors. Furthermore, you can only purchase or redeem the units of a bond mutual fund from the Asset Management Company (AMC) that created it in the first place. This severely limits liquidity as the AMC can refuse to redeem the bond units citing various reasons. A bond ETF, thankfully, has no such drawbacks. As long as there’s enough demand, you can easily purchase and sell units on the stock exchange without any restrictions whatsoever. 

Advantages and Disadvantages of a Bond ETF

Bond ETFs in India come with their own set of benefits and drawbacks. As an investor, you need to know what they are to make a well-informed investment decision. And so, here’s a quick overview of some of the key advantages and disadvantages of these unique financial instruments. 

Advantages of Bond ETFs

• Bond ETFs invest in a wide range of bonds with different interest payment dates. This creates a regular stream of income throughout the year. 
• Most bond ETFs are passively managed and often have very low expense ratios. 
• Bond ETFs reduce the overall investment risk by investing in multiple bond categories and credit ratings. 
• Bond ETFs support Systematic Investment Plans (SIPs), enabling investors with limited capital to gain access to the bond market.  

Disadvantages of Bond ETFs 

• A bond ETF has no fixed maturity date. This puts your initial investment at a slightly higher risk compared to a regular bond. 
• If the interest rates rise, the value of the ETF often plummets. This combined with the lack of a fixed maturity date makes mitigating interest rate risk far more challenging compared to a regular bond.  
• The returns from a bond ETF often tend to be much lower than other market-linked instruments. 

What are Some Common Types of Bond ETFs? 

You can find many different types of bond ETFs, both focused and diversified, listed on the Indian financial market. Here’s a quick look at some of the most common types. 

• Corporate Bond ETFs

As the name implies, corporate bond ETFs invest in a basket of different corporate bonds. These ETFs can be further classified into investment grade and junk bonds depending on the credit rating of the bonds in the portfolio. 

For instance, investment-grade corporate bond ETFs consist of highly rated bonds ranging from AAA to BBB. These bonds typically offer lower interest but better safety. Junk bond ETFs, on the other hand, invest in bonds with low credit ratings. However, the rate of return offered by these ETFs is often higher than investment-grade funds.  

• Government Bond ETFs

Government bond ETFs invest in a basket of different government bonds such as T-Bills, long-term G-Secs and State Development Loans (SDLs), among others. The interest payments from these ETFs often tend to be far lower compared to corporate bond funds. However, since the bonds in the fund’s portfolio are all backed by a sovereign guarantee, they’re completely free from default risk. 

• Broad Market Bond ETFs

Broad market bond ETFs invest in a mix of both corporate and government bonds. Such exchange-traded funds often have a more balanced risk-reward ratio compared to the other two categories of bond ETFs.  

Conclusion 

With this, you must now be aware of the definition of a bond ETF and its benefits and drawbacks. Since a bond ETF invests in a basket of different bonds across different segments and credit ratings, it is one of the best ways to gain exposure to the bond market. 

If you’re planning to invest in a bond ETF for the long term, remember to choose a well-diversified one. This will enable you to effectively reduce your portfolio risk irrespective of how the market moves. 

On the other hand, if you’re planning to actively trade in a bond ETF, remember to use trading strategies with strict risk management plans in place to minimise downside risk.