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August 8, 2002
"Bond Exchange Traded Funds, or Bonds Disguised as Stocks"
For several years, one of the hottest new products on Wall Street has been Exchange Traded Funds (ETFs). These funds are traded like any other stock on the American Stock Exchange, but they are made up of a basket of stocks in either a broad index, like the S&P 500 (known as SPIDERS), or the Dow Jones Industrials (known as Diamonds), or a narrow index representing a single country or industry group.
Now, for the first time, ETFs have been introduced allowing you to buy bond indexes of various maturities. The three that came out first -- clearly there will be many more to come -- are: the short 1-3 year maturities, known by the symbol SHY; the intermediate maturities of 7-10 years, under the symbol IEF; and the long-term maturities of 20 years, under the symbol TLT. All of these only offer super-safe government Treasury bonds.- There are several advantage to buying bonds in the form of a stock:
- If you buy or sell individual bonds in small quantities from a broker, there is a wide spread between the buy and sell price, which is hidden, but costly, to the small investor. Bond ETFs have no such spread.
- You can buy and sell these ETFs any time during the day that you want, just like any other stock. If you buy a bond index fund, you only get the price at the end of the day, which may or may not be an advantage, depending on what happens to the bond market that day.
- These ETFs will always trade at their net asset value, which is the worth of their underlying portfolios. Many closed-end bond funds sell at 10 to 15 percent discounts from NAV, so if you buy it at par, you lose money as it drops to a discount. That won’t happen with ETFs.
- There is no credit risk of default with these ETFs because they are buying government bonds, so they are very safe in a volatile environment.
- Income from ETFs will be taxable, but they will not distribute capital gains like bond mutual funds because they are not trading the portfolio at all, making them highly tax-efficient.
- ETFs have a much lower expense ratio than bond funds. ETFs will charge 0.15 percent per year, versus .2 percent to 1 percent for other bond funds.
- But, of course, there are some cautions about Bond ETFs:
- You can still lose money if interest rates rise, hurting the value of the underlying bond.
- If you are in a high enough tax bracket, buying muni bonds will probably give you a higher after-tax return than a taxable Treasury ETF.
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