Bond ETFs vs. Bonds: Which Are Better?

Learn the differences between bonds and bond ETFs and see which is best for you.

kent
|
Research Lead
Reviewed by: etf.com
,
Edited by: Mark Nacinovich

 

 

Bond ETFs and individual bonds share some similarities, but there are many differences, as well as advantages and disadvantages associated with each investment type, for investors to consider. The choice between them depends on factors such as an investor's financial goals, risk tolerance and the desired level of involvement in managing their fixed-income investments. 

Learn the differences between bond ETFs versus bonds, as well as an outlook on the bond market, to see which fixed income security is the best fit for your portfolio. 

The Definition of Bond ETFs 

A bond ETF is an exchange-traded fund that seeks to replicate the returns of an underlying bond benchmark, such as the Bloomberg US Aggregate Bond Index. As an ETF, this type of fund trades on an exchange, which provides investors with a convenient and cost-effective way to invest in a diversified portfolio of bonds. 

The diversification provided by bond ETFs helps spread risk across different issuers and types of bonds, which may include government bonds, corporate bonds, municipal bonds and other fixed-income securities. The exchange-traded aspect of bond ETFs means that investors can buy and sell shares of bond ETFs throughout the trading day at market prices, offering liquidity and flexibility. 

The Difference Between Bonds and Bond ETFs 

The main difference between bonds and bond ETFs is how they are structured. For example, when investors buy individual bonds, they are purchasing a specific debt security issued by a government, municipality or corporation. Whereas bond ETFs are structured like mutual funds but are traded on an exchange throughout the day.  

This difference in structure brings about other differences, including diversification, liquidity and income distribution. 

Differences between bonds and bond ETFs include: 

  • Diversification: Investors in individual bonds hold a specific bond issued by a single entity. Bond ETFs offer diversification by holding a portfolio of bonds, meaning ETF investors indirectly own a fraction of each bond in the portfolio, providing exposure to a variety of issuers and maturities. 
  • Liquidity: The liquidity of individual bonds depends on factors such as the specific bond's issuance size, credit rating and prevailing market conditions. Traded on stock exchanges, bond ETFs provide intraday liquidity, allowing investors to buy or sell shares throughout the trading day at market prices. 
  • Income distribution: With individual bonds, investors typically receive semiannual or annual interest payments directly from the issuer, and they may receive the face value of the bond at maturity. With bond ETFs, investors typically receive monthly income distributions in the form of dividends originating from the interest payments made by the bonds in the ETF's portfolio. 
  • Maturity: Individual bonds have a fixed, unchanging date at which they mature, and investors get their money back; each day invested is one day closer to that result. Bond ETFs do not mature and typically attempt to maintain a weighted average maturity or duration. As a result, additional bonds are continually being bought and sold to keep the portfolio's maturity constant.  
  • Minimum investment: Purchasing individual bonds typically requires a larger initial investment, often in increments of the face value of the bond. Investors can buy shares of bond ETFs with a relatively small investment, as they are priced based on the market value of the ETF. 
  • Management: Investors who hold individual bonds are responsible for managing their bond portfolio, including selecting bonds, monitoring credit risk and reinvesting as bonds mature. Bond ETFs can be passively managed, tracking a specific bond index, or actively managed by professional portfolio managers who make strategic decisions about the portfolio composition. 
  • Market price vs. face value: The market price of an individual bond can fluctuate, but it is typically influenced by changes in interest rates and the creditworthiness of the issuer. If an investor holds an individual bond until maturity, however, he or she will receive the face value. The market price of a bond ETF is determined by supply and demand in the secondary market. It may trade at a premium or discount to its net asset value, or NAV. 

Advantages of Investing in Bonds and Bond ETFs 

Bonds and bond ETFs have similar and unique advantages for investors to consider before choosing which is better for their investments needs. 

Advantages of Investing in Bonds 

  • Regular income: Bonds typically pay periodic interest payments, known as coupons, to bondholders. This provides a predictable and regular stream of income, making bonds attractive for income-focused investors, retirees and those seeking cash flow. 
  • Capital preservation: The return of principal is a key feature of bonds, especially if the bond is held until maturity. This makes bonds a potentially less risky investment compared to stocks and some bond ETFs. 
  • Stability in turbulent markets: During periods of market volatility or economic uncertainty, bonds often act as a safe-haven asset, especially government bonds, which are considered low-risk investments and tend to attract investors seeking stability. 
  • Risk management: Different types of bonds carry different risk profiles. By carefully selecting bonds based on credit quality, maturity, interest rate risk and other factors, investors can tailor their bond investments to manage specific risks within their portfolio. 
  • Tax advantages: Certain types of bonds, such as municipal bonds, may offer tax advantages. Interest income from municipal bonds is often exempt from federal income taxes, and in some cases, state and local taxes, providing tax-efficient income. 

Advantages of Investing in Bond ETFs 

  • Diversification: Bond ETFs provide instant diversification by holding a portfolio of bonds that can be diversified across risk across different issuers, maturities and sectors. Investors gain exposure to a broad range of bonds without having to purchase individual securities. 
  • Liquidity: Trading like stocks on an exchange, bond ETFs provide investors with intraday liquidity, allowing them to buy or sell shares throughout the trading day at market prices. The ability to trade ETFs on an exchange enhances liquidity compared to traditional mutual funds. 
  • Accessibility: Bond ETFs can be bought and sold through brokerage accounts, making them accessible to a wide range of investors with varying levels of investment capital. 
  • Lower investment minimums: Investing in a bond ETF requires a lower minimum investment compared with building a diversified portfolio of individual bonds. 
  • Professional management: Bond ETFs can be passively managed or actively managed by professional portfolio managers. This can be beneficial for investors who prefer a hands-off approach to managing their fixed-income investments. 
  • Income generation: Bond ETFs typically produce regular distributions, often in the form of monthly dividends, providing a consistent income stream that can be attractive for income-oriented investors. 
  • Cost efficiency: Bond ETFs often have lower expense ratios compared to actively managed bond mutual funds. The efficiency of the ETF structure allows for cost savings, contributing to a more cost-effective investment option for investors. 
  • Potential tax efficiency: Bond ETFs may be more tax-efficient than certain actively managed bond funds. The "in-kind" creation and redemption process of ETFs can help minimize capital gains distributions, potentially offering tax advantages for investors. 
  • Intraday pricing: Unlike traditional mutual funds, which are priced at the end of the trading day, bond ETFs are priced and traded throughout the day. This intraday pricing allows investors to react to market conditions and news events in real-time. 
  • Options trading: Some bond ETFs have options traded on them, providing additional strategies for investors to manage risk or enhance returns through options trading. 

Disadvantages of Investing in Bonds and Bond ETFs 

While bonds and bond ETFs each offer investors multiple benefits, there are potential risks and other disadvantages that investors should understand before choosing between the two. 

Disadvantages of Investing in Bonds 

  • Interest rate risk: Bond prices are inversely related to interest rates. When interest rates rise, bond prices tend to fall, and vice versa. This interest rate risk can result in capital losses for bondholders, especially if they need to sell bonds before maturity. 
  • Credit risk: Also known as default risk, credit risk is the risk that the issuer of a bond may fail to make interest payments or repay the principal at maturity. Bonds with lower credit ratings generally offer higher yields but come with increased credit risk. 
  • Inflation risk: Inflation erodes the purchasing power of money over time. Fixed-rate bonds may not keep pace with inflation, meaning that the real (inflation-adjusted) return on investment may be lower than expected. 
  • Reinvestment risk: When interest rates fall, investors may face reinvestment risk. This occurs when maturing bonds are reinvested at lower interest rates, potentially reducing the overall income generated by the bond portfolio. 
  • Liquidity risk: Some bonds, especially those with less frequent trading, may lack liquidity in the secondary market. Investors may face challenges selling these bonds at desired prices, especially during periods of market stress. 
  • Market risk: The overall performance of the bond market can be influenced by macroeconomic factors, geopolitical events and changes in investor sentiment. Market risk can affect the value of a bond portfolio. 
  • Call risk: Callable bonds give issuers the option to redeem the bonds before maturity. If interest rates decline, issuers may choose to call and refinance their debt at lower rates, leading to the early retirement of higher-yielding bonds and potential reinvestment challenges for bondholders. 
  • Currency risk (for international bonds): Investors in bonds denominated in foreign currencies face currency risk. Fluctuations in exchange rates can affect the returns earned by investors when converted back to their home currency. 
  • Economic and industry risks (for corporate bonds): Corporate bonds are subject to economic and industry-specific risks. A company's financial health, business model and industry conditions can affect the performance of corporate bonds. 
  • Complexity: Bond investing requires careful consideration of various factors, including credit quality, duration and yield. Investors may find it challenging to navigate the complexities of the bond market and select suitable securities. 
  • Tax implications: Depending on the investor's tax situation and the type of bonds held, interest income may be subject to federal, state and local taxes. Tax considerations can affect the after-tax return on bond investments. 
  • Limited performance: While bonds provide regular income through interest payments, they may have limited capital appreciation potential compared with some other investments like stocks. Investors seeking significant capital gains may find other asset classes more suitable. 

Disadvantages of Investing in Bond ETFs 

  • Interest rate risk: Like individual bonds, Bond ETFs are subject to interest rate risk. When interest rates rise, bond prices typically fall, and this can lead to capital losses for investors in bond ETFs. The degree of interest rate risk depends on the duration of the bonds held in the ETF's portfolio. 
  • Credit risk: Bond ETFs hold a portfolio of bonds, and the credit quality of these bonds can vary. If the ETF holds bonds with lower credit ratings, it may be exposed to higher credit risk. Defaults or downgrades of the underlying bonds can have an impact on the ETF's performance. 
  • Market price vs. net asset value: The market price of a bond ETF can deviate from its net asset value. While the creation and redemption mechanism in ETFs helps keep prices close to NAV, during periods of market stress or illiquidity, the market price may temporarily diverge. 
  • Tracking error: The performance of a bond ETF may not perfectly replicate the performance of the index it aims to track. Factors such as transaction costs, management fees and the timing of trades can contribute to tracking error. 
  • Intraday price volatility: Bond ETFs are traded on stock exchanges, and their prices can be subject to intraday volatility. That can be more pronounced during periods of market stress, and investors may experience price fluctuations even if the value of the underlying bonds remains relatively stable. 
  • Premiums and discounts: Bond ETFs may trade at a premium or discount to their NAV. This can occur due to supply and demand factors, liquidity issues in the bond market, or market sentiment. Investors may face the risk of buying at a premium or selling at a discount, especially in an ETF with low assets under management and low trading volume. 
  • Market conditions affect returns: Bond ETF returns are influenced by market conditions, including interest rates and credit spreads. In certain market environments, such as rising interest rate environments or economic downturns, bond ETF returns may be affected. 

Bond Market Outlook for 2023 and 2024 

In recent years, the Federal Reserve has been raising interest rates aggressively in an effort to combat high inflation. That has placed downward pressure on the prices of bonds and bond ETFs, as investors can buy new bonds with higher yields. If inflationary pressures continue, prices for bonds and bond ETFs could continue to fall, especially for long-term bonds, which are rate sensitive. 

With the Fed rolling off its balance sheet, and not buying new Treasuries as older ones mature, the bond market has faced liquidity challenges that could continue while the Fed maintains this quantitative tightening process. In times of market stress and illiquidity, it can be difficult to sell bonds and bond ETFs at a fair price. This is because there may be fewer buyers in the market. 

Many analysts expect the U.S. economy to slow, or even enter a recession in 2024. That could alleviate the downward pressure on bond prices or possibly make prices go up, which would send yields lower. 

In an environment of such uncertainty, investors are wise to consider diversification, which would entail investing in a variety of different bonds, including government bonds, corporate bonds and municipal bonds. It can also be smart to invest in a range of duration: Shorter maturities can provide yield without as much interest rate risk as longer-duration bonds, and longer maturities can provide a recession hedge, meaning they may climb in price if the economy slows more than expected. 

Bonds vs Bond ETFs: Which Is Best? 

Choosing between bonds versus bond ETFs depends on various factors, including an investor's financial goals, risk tolerance, investment horizon and preferences. Here are some considerations for both options: 

Invest in Individual Bonds If: 

  • You prefer to customize your bond portfolio by selecting specific bonds based on factors such as credit quality, maturity and issuer. 
  • You want to implement a laddering strategy, where you stagger the maturities of individual bonds to manage interest rate risk and provide a steady stream of income. 
  • You have a clear preference for holding bonds until maturity to ensure the return of principal and are less concerned with market fluctuations in bond prices. 
  • You have specific income needs and want the flexibility to design a portfolio that generates a predictable stream of cash flow through interest payments. 
  • You prefer direct ownership of the underlying bonds, allowing you to have a more direct relationship with the issuers. 

Invest in Bond ETFs If: 

  • You seek instant diversification by gaining exposure to a broad range of bonds without the need to purchase and manage individual securities. 
  • You value the intraday liquidity of ETFs, allowing you to buy or sell shares on stock exchanges at market prices throughout the trading day. 
  • You prefer professional management of your bond portfolio and want the expertise of portfolio managers to make decisions on asset allocation and security selection. 
  • You have a smaller investment amount and may not meet the minimum investment requirements typically associated with building a diversified portfolio of individual bonds. 
  • You are cost-conscious and appreciate the potentially lower expense ratios of bond ETFs compared to actively managed bond mutual funds. 
  • You want the flexibility to easily adjust your exposure to different sectors, maturities, or credit qualities by buying or selling shares of an ETF on the stock exchange. 
  • You are concerned about reinvestment risk and want the ability to reinvest the proceeds from maturing bonds or interest payments without the need for active management. 
  • You are interested in tracking broad market trends and prefer the transparency of knowing the holdings of the ETF, which is disclosed regularly. 

The Bottom Line on Bond ETFs vs. Bonds 

Ultimately, the decision between individual bonds and bond ETFs depends on your individual preferences, investment strategy and specific financial circumstances. While there are significant differences that investors should understand, bonds and bond ETFs share many of the same qualities, such as income generation and suitability for conservative strategies. Some investors may find a combination of both approaches to be appropriate for their overall fixed-income allocation.

Kent Thune is Research Lead for etf.com, focusing on educational content, thought leadership, content management and search engine optimization. Before joining etf.com, he wrote for numerous investment websites, including Seeking Alpha and Kiplinger. 

 

Kent holds a Master of Business Administration (MBA) degree and is a practicing Certified Financial Planner (CFP®) with 25 years of experience managing investments, guiding clients through some of the worst economic and market environments in U.S. history. He has also served as an adjunct professor, teaching classes for The College of Charleston and Trident Technical College on the topics of retirement planning, business finance, and entrepreneurship. 

 

Kent founded a registered investment advisory firm in 2006 and is based in Hilton Head Island, SC, where he lives with his wife and two sons. Outside of work, Kent enjoys spending time with his family, playing guitar, and working on his philosophy book, which he plans to publish in the coming year.