When bonds are wrapped up in an exchange-traded fund (ETF), their values change as yields increase or decrease. Find out what goes on beneath the surface.
When you have a bunch of bonds wrapped up in an exchange-traded fund (ETF), their values change as yields increase or decrease. But what really goes on beneath the wrapper?
New exchange-traded funds (ETFs) have been rolling off the assembly line ever since the concept was first cooked up, giving self-directed traders and investors additional securities to add to their watch lists. But ETFs aren’t all alike. ETFs of different asset classes may generally serve the same purpose, but their mechanics can vary.
When equities show signs of trouble, investors and traders often turn to bonds. But bonds trade differently from stocks. Does that mean bond ETFs also trade differently?
Bond ETFs can be made up of many bonds that target different sectors—anything from U.S. government bonds to emerging market debt.
When you invest in bonds, you receive a regular payment plus the principal. So why do bond values change? The answer can get complicated. Just remember that the relationship between a bond’s coupon and its prevailing price is in the bond’s yield. When the bond’s market price declines, its yield goes up. When the price increases, the yield goes down. But bond ETFs hold many bonds with different yields and maturity dates. How is an ETF’s yield calculated?
There are different ways to calculate the yields of bond ETFs—the 30-day SEC yield, average yield, distribution yield, and 12-month trailing yield, to name a few. Municipal bonds and Treasury Inflation Protection Securities use other measures. In addition to yield measurement metrics, there’re some additional points to consider.
Bond ETF values. When bond prices fall, the value of bond ETFs are likely to follow suit. Prices are inversely related to interest rates, so when rates rise, bond values fall.
Interest payments. Bond investors receive regular payments, usually every six months. Because bond ETFs hold multiple bonds, investors often receive coupon payments more frequently, typically monthly. Payments may vary from month to month.
Index tracking. Bond ETFs typically track a specific bond index, so they include only the select bonds that best represent an index. All bonds aren’t included because of the over-the-counter nature of the bond market. Acquiring all the bonds could lead to high transaction costs.
Pricing. Bonds aren’t traded on exchanges the way stocks are, but most highly liquid bond ETFs trade on a stock exchange or secondary market. This allows investors to buy and sell bond ETFs on the exchange. Some bond ETFs trade on the primary market, which involves the creation or redemption of ETF shares by authorized participants (APs), who are broker/dealers or market makers. A bond ETF’s price is usually an estimate. Because ETFs are traded on an exchange, their prices can vary from the value of the underlying bonds. But arbitrage by authorized participants helps keep the ETF prices in line with the NAV of the underlying bonds.
Even though bonds trade differently from stocks, when they’re wrapped up in an ETF, mechanisms are put in place that make bond ETFs trade more like their equity counterparts. Still, they’re not exactly the same. There’s more to bond ETFs than the price and volume data you see on your screen. Knowing how the underlying bonds work and how they affect ETF prices can add another dimension to your analytical skills.
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